By Guest commentary Friday, July 13th, 2012

By Bridget Foreman on July 13, 2012

The Internal Revenue Service has ramped up its efforts in recent years by expanding its audits of the wealthiest individuals. Particularly over the last five years, the IRS audit rates increased on average 10 percent and the percentage of audits for those with income more than $1 million nearly doubled.

In 2009, the IRS established a specialized task force to audit the ultra-wealthy, named the Global High Wealth Industry Group. The task force, overseen by the IRS’s Large Business and International Division, was created to observe and investigate business entities, trusts and assets controlled by high net worth individuals.

The main goals of the task force are to assess tax compliance among the ultra-wealthy, defined as those who have income and assets totaling $10 million or more, and then to uncover the veracity of the tax system. The audits of the nation’s wealthiest taxpayers have been on the rise. As a result, the IRS forecasted earlier this year that those who fall into this ultra-wealthy category are 30 percent more likely to be audited.

As we’ve recently read in the Business Times’ Region’s Richest special report, some of the nation’s most affluent individuals have established deep roots on the Central Coast and built their successes throughout the local landscape. With the chance of being audited much higher for those making more money, an increase in financial audits in our region is foreseeable.

When creating the task force, IRS Commissioner Douglas Schulman said that many high-net worth individuals operate under sophisticated business, finance and investment arrangements that are perfectly legal, while others attempt to cover aggressive tax strategies. The task force concentrates on ferreting out such practices amongst those with significant wealth to ensure that all taxpayers are abiding by tax laws.

According to recent reports, there are certain red flags that make the ultra-wealthy more likely to be audited by the task force. The following highlights the IRS’s red flags that may prompt these audits:

• You own a business: When sole proprietors report their taxes on Schedule C forms, there is an increased ability to manipulate numbers, hide income and skim profits. The IRS critically assesses Schedule C forms, so it is advised to always report all earnings accurately.

• You have a home office: Many taxpayers deduct the cost of working from home, which is perfectly acceptable. However, if you qualify for a home office deduction — if your office is your primary workplace — be weary of the costs you document. If you attempt to deduct areas of your home that you use for work, but also serve other functions, the IRS may find reason to audit your statements. Instead, be cautious about the expenses you deduct and keep supporting expense reports for such costs.

• You have foreign assets: Beginning this year, taxpayers are required to report any foreign bank accounts and foreign assets— including pension funds and foreign stocks — that total more than $50,000.

The IRS is attempting to put an end to hiding income in overseas accounts; thus, the agency will waive certain penalties and jail time for those who provide information about foreign assets and accounts that they had previously not disclosed. If you fail to provide information about foreign assets, the IRS may become skeptical of your involvement with foreign accounts and your likelihood of being audited increases.

• You guess on investments: Previously, the IRS only required that brokers provide the agency with the date a stock was sold and how much gross proceeds were received from the investment. That method often left people guessing about basis and providing incorrect information on their Schedule D capital gains and losses statement, intentionally or not, which resulted in less taxes paid. Now, the IRS is double checking numbers and dates with brokers, including some basis information, to ensure that taxpayers pay the appropriate amount of tax. If the data does not match, an audit is likely.

• You give to charity often: Taxpayers who donate to charitable causes frequently, or in large quantities, are sometimes tempted to exaggerate the amount of money or items they donated. However, it is advised to be conservative, realistic and very specific when deducting the amount of charity you provided. If your donation amount is over $250, it is necessary to have supporting documentation from the receiving charity. The IRS becomes skeptical of charitable deductions when there is a lack of supporting documents and when the donation amounts are unusually high in comparison to income.

• You selected an inexperienced tax preparer: When a tax preparer lacks experience and is therefore not equipped to prepare sophisticated tax returns, it increases a taxpayer’s chances of getting audited. If your accountant claims far-fetched deductions and credits without proper documentation, you are still legally responsible for those fraudulent acts.

It is wise to select an experienced accounting firm to ensure that your deductions are legally applicable to your return and you do not pay more than you owe.

Although the above situations are red flags for the IRS’ high-wealth task force and reflect scenarios pertinent to the ultra-wealthy, all taxpayers should be diligent about obtaining and maintaining evidence which supports the income and deductions reported on their tax returns.

• Bridget Foreman is a partner with Santa Barbara-based CPA firm Bartlett, Pringle & Wolf LLP. Contact her at (805) 963-7811 or [email protected].