How High-Income Taxpayers Can Prepare For A Likely Audit

Recent increases to the operating budget of the IRS have been much publicized and criticized.  Fears of tens of thousands of new agents, armed with billions of additional funding in the budget, have caused taxpayers to complain about potential overreach.  While this additional enforcement may not impact most taxpayers, the IRS will almost certainly target at least one group of taxpayers: high-income and wealthy individuals.

These individuals and businesses should prepare for a heightened scrutiny of issues long untested by the IRS.  While 2023 was viewed administratively “as a year to try hiring up,” the agency expects to implement additional enforcement in the next few years to close the ever-growing tax gap.  For instance, within its most recent Strategic Operating Plan, the IRS states it will increase audit rates by more than 50% on wealthy individual taxpayers with total positive income over $10 million, with audit rates going from an 11% coverage rate in 2019 to 16.5% in tax year 2026.”  Since the statute of limitations for assessment is typically three years, and IRS agents are authorized to examine and assess for that period while conducting an audit, the percentage of tax returns for high-income taxpayers subject to scrutiny could approach 50%.  According to the IRS, this will help restore future audit rates to those seen historically (e.g., the audit rate for taxpayers earning $1 million or more was 0.7% in 2019 compared to 7.2% in 2011).  And, with historical returns of more than $12 in revenue for every $1 spent in enforcement relating to high-income taxpayers, this administrative decision is justifiable.

But, aside from auditing significantly more tax returns for this group of taxpayers, what will the IRS focus on?  For one, the agency will be targeting millionaire households that have not submitted tax returns in recent years.  These individuals are “low hanging fruit” for the IRS and likely face significant liabilities.  Additionally, the agency indicates it will target common unscrupulous tax reporting practices, including those abusing rules for corporate jet use, those related to residency in Puerto Rico, those involving cryptocurrency and digital assets, those involving interests in complex partnerships, and abuses of international tax rules.  Some of these are relatively uncharted areas where there is either a lack of, or evolving, guidance from the IRS and the courts.  Other red flags to be audited by the IRS include “aggressive valuation discounts” on assets, estate and gift tax returns, and more traditional items like “passive losses” and understated income on a Schedule C.  These focus areas will evolve as the IRS continues data mining from audits and other ongoing initiatives.

How can these individuals be prepared for such an audit? High-income taxpayers should prepare their tax returns under the assumption that they will be reviewed in detail.  Proper preparation includes obtaining professional guidance regarding all material positions reported on an income tax return and properly disclosing uncertain items to the IRS.  Where novel or “aggressive” positions are taken, taxpayers should document the advice sought in advance of the filing.  At the very least, if the position is justifiable, such disclosures and advice may mitigate the possibility of proposed penalties.  But such work on the front end – with proper explanation and substantiation – may also help to avoid the assessment of all, or at least a part of, additional tax related to these types of issues.

Further, upon notification of an audit, taxpayers should engage a tax attorney – not simply their tax preparer – to form an appropriate strategy to defend positions in an audit, administrative appeal, and, if necessary, the federal courts.  For high-income non-filers, who can expect to “receive tailored, proactive outreach before receiving automated assessments or penalties,” it goes without saying that they should immediately contact a tax professional to proactively address their delinquencies.  The chance of avoiding significant civil and criminal penalties decreases significantly with the passage of time and after contact from the IRS.

Given the potential high financial stakes in any audit involving the IRS, taxpayers are well-advised to contact a tax audit lawyer to advocate for them.  Proper advice can help to minimize the potentially significant civil and criminal consequences of noncompliance.

Thank you to the team at Crepeau Mourges for the above blog.