You might have read earlier this month that the IRS is targeting poor people for tax audits at a rate four times higher than the wealthy.
But that’s not entirely true. And depending on your circumstances, the odds of an IRS audit could increase sharply.
Americans submit nearly 165 million individual tax returns annually. In fiscal year 2022, which ended last September 30, the IRS audited 626,204 returns; 0.38% of returns filed. That’s down sharply from audit rates in previous years. For instance, in 2011, the audit rate was around 0.9%.
The mainstream media has highlighted the fact that some of the highest audit rates – around 1.27% – are of low-income workers claiming a tax break called the “earned income credit.” And memorably, in 2019, former IRS Commissioner Charles Rettig admitted that the agency targets tax returns filed by the poor because it’s “easier and cheaper” than auditing the rich.
Still, wealthy taxpayers – those who report income of $1 million or more annually – undergo audits at a much higher rate than those with lower income. For instance, in 2022, households with an annual adjusted gross income (AGI) exceeding $1 million were audited at a rate of 2.38%.
What’s more, thanks to the IRS’s data processing capabilities, every tax return is subjected to computer scoring and compared to other returns of people with similar income and occupations. The effective audit rate is therefore 100%; not 0.38%.
If the IRS’s return processing software detects discrepancies that exceed predetermined variances, you could receive a computer-generated letter seeking an explanation. The letter could also inform you that you won’t receive the refund you thought you were entitled to, or that you’ve had your deductions disallowed.
These letters are often worded cryptically and may require you to cross-reference its statements with a list of possible explanations. But if you want to ask the IRS for an explanation, good luck getting through on the phone. During the 2022 filing season, only about 10% of calls reached an IRS employee. Callers that did get through often had to wait for hours on hold.
Other than being wealthy – or attempting to qualify for the earned income credit –business owners, workers in the gig economy, and cryptocurrency investors also face a heightened audit risk.
Business owners. In 2022, taxpayers who didn’t report business revenue were audited at a 0.49% rate. But those reporting similar incomes from a business or farm were audited at more than double that rate; 1.03%. A major focus of business audits is on pass-through entities like S corporations and LLC. The IRS claims they’re difficult to audit because they frequently have complex structures that can involve dozens of inter-related entities. And while it’s true that some taxpayers use complex structures to operate a business, the vast majority create entities with just one or two owners and involve no intervening structures.
Gig economy. Congress seems to believe millions of mostly lower-income Americans who work in the gig economy are enemies of the state. Thus, the American Rescue Plan, which Democrats rammed through Congress in 2021, reduces the reporting threshold for payments received through apps like Venmo and PayPal from $20,000 to $600 per year. This income was always taxable, but thanks to Congress, payments from any such app exceeding $600 annually will be on the IRS radar.
Cryptocurrency investors. As if the catastrophic fall in value for most cryptocurrencies over the last 18 months isn’t bad enough, the IRS believes that many cryptocurrency users aren’t paying tax on their gains. Since 2016, it’s issued John Doe summonses against Coinbase, the country’s largest bitcoin exchange, along with other cryptocurrency companies. (The IRS uses John Doe summonses when the agency doesn’t know the identity of specific individuals who might have a tax delinquency. Instead, they demand access to all records so they can comb through them one by one.) Based on the data retrieved through these inquiries, beginning in 2019, the IRS sent more than 10,000 letters to taxpayers who potentially failed to report their cryptocurrency income.
Going forward, in 2022, President Biden signed the Inflation Reduction Act, which gives an $80 billion boost to the IRS budget over the next decade. A big chunk of the money will be used to hire 87,000 new IRS agents. While we don’t believe the new hires pose an immediate threat to taxpayers, count on significantly higher audit rates in the years ahead, especially if you have above-average income.
Also keep in mind that it’s surprisingly easy to commit a tax crime. One of the easiest crimes to prove is low-level wrongdoing, such as submitting a false withholding Form W-9 to an employer, claiming several deductions when you’re only entitled to legitimately claim one. Even submitting a false return where there is no tax liability can result in criminal violation. Most of the time, the IRS doesn’t target such relatively minor offenses, but if you come to the agency’s attention for some other reason, it could.
Of course, the IRS audit process is just one example of the flawed operation of this feared agency:
Every taxpayer, rich or poor, must contend with the IRS’s shoddy cybersecurity record.
Believe it or not, if you file taxes online, your data is probably being shared with Facebook.
If you owe the IRS more than $59,000 in tax, interest and penalties, your US passport could be confiscated.
Our suggestion is not to get caught in a war with the IRS. You’re unlikely to win. Protect yourself by hiring a qualified tax professional who can make certain you file all required forms and pay the correct tax. Keep records substantiating the income and deductions you claim on your tax returns and proof that you filed.