“Random Audits” are Back!

My oldest son is taking his college course in Government. I never had the benefit of an esteemed professor teaching me about the government, so pardon my uneducated opinion on the subject. Here it is: Government is not your friend, and Government will always find new creative ways to make our lives – well, let’s say busier…

Here is a fresh proof: the IRS announced that they are restarting the “random audits” program. Let me provide some background.

Most of the tax returns are audited for a reason. Good reason or bad reason – is a different story, but some reason anyway. For example, if you have 10 rental properties that each brings you $5,000 of rent a year, and then you have $15,000 of “repairs” on each of those 10 properties – well, this might be a reason why they want to talk to you.

The only good part about this kind of audits is that the IRS lets you know what exactly they are interested in. In this case, they will ask you to prove your $150,000 worth of “repairs.” You may or may not win this audit (and I doubt you will), but at least you can prepare for it. Even more importantly, you can reduce your chances of being audited by being more reasonable with your figures.

Contrast this with “random audits” that were common in the 80’s and early 90’s. In a “random audit”, you are selected at random – meaning, for no reason at all. Simply your Social Security number was picked by the IRS computer. What’s the problem, if you did nothing wrong with your taxes? The problem is that they will be checking everything on your tax return. And I mean everything. Every little deduction, no matter how “clean” it is. They are not trying to catch you, they are just verifying your entire tax return.

A good analogy will be airport security. If the X-Ray machine shows something suspicious, the security will open your bag and inspect this specific item. At my recent flight to Phoenix, they did not like my toothpaste tube and made me throw it in garbage. I guess, they did not realize that the real threat to flight safety was my bad breath, not the toothpaste. Now, compare opening one bag to a full strip search: the kind when they will make you remove all your clothes and will pull out every single pair of socks from your luggage. This is what “random audit” is. Enjoy.

In the mid-90s, America got fed up with the feds. The Congress held extensive hearings on the IRS methods, and the Congress wisely concluded that it was bad. Some reasonable managers with business background were hired to lead the new IRS; the worst forms of abuses were outlawed; the “random audits” program was stopped.

As you should have expected, only temporarily…

Why you should have expected it? Because, as you can probably learn from any college course in Government, the Government is a swinging entity. It cannot stay in the middle; it must go from one extreme to the other, like your Grandfather’s clock. The IRS reform did not stop just the abuses – it pretty much stopped most of the IRS enforcement activity. For a few happy years, we had a lull: very few audits and relatively friendly collection. Living on the Gulf Coast, we know what a lull means: a serious storm is forming somewhere close. Board up your windows. Just like your Grandfather’s clock, the IRS is in full swing back.

The same Congress that in the 90’s had told the IRS to hold back, now looked at the results and discovered that the IRS is not collecting taxes for the Government. They even invented a new buzzword: “The Tax Gap” – meaning the difference between the taxes that should be collected and the taxes actually collected. Wonder how much? About $350 billion per year. This is roughly $1,000 for each US resident, including children and everyone else who does not pay taxes. I’d estimate it means $3,000 – $5,000 per tax return.

Guess what the Congress wants the IRS to do about it now? Exactly, start collecting taxes – again! You may be happily unaware yet, but in the recent couple years, the audit rate practically doubled every year. You want to guess which sector has the fastest growth in number of IRS audits? Right again: small businesses and self-employed. Folks – this includes us!

Now, on top of the already alarming growth in audits, the IRS is restarting “random audits.” The first 13,000 victims will be notified this October. Yes, it is a very small number, but it is a start. I want you to look at the selection criteria that the IRS announced for this renewed program:

  • are self-employed
  • have businesses with high cash flow
  • have zero withholdings on their income
  • have income that is not separately reported to the IRS (i.e. no 1099s)

Did I get your attention yet? If not yet, then let me quote what the IRS expressed as a “particular concern”: “…the basis of assets sold and reported on the Schedule D…” The IRS suspects (and, by the way, rightly so!) that the basis of sold assets is routinely “overstated.”

So, what do I suggest? Nothing really different from what I have been suggesting for years: do not cheat, and keep good records. Since the audits are fact of life, and now MORE audits will be fact of life, all we can do is be ready. When it comes to the IRS, nothing will help you more than good records. This is why I teach classes on Bookkeeping for investors.

Leave a Comment

Your email address will not be published.