The federal government and Massachusetts government are in desperate need of money. The federal budget deficit is estimated at $1.6 trillion this fiscal year. Here in Massachusetts, the state is trying to close a $2.75 billion budget gap. Increasing taxes in an election year is a political taboo. However, the government also employs less overt strategies to increase tax revenues. One strategy being used by both the US and Massachusetts government is to increase tax enforcement. The most typical tax enforcement activity is an audit by either the Internal Revenue Service (IRS) or the Massachusetts Department of Revenue (DOR).
Last June, the Massachusetts Legislature and Governor Patrick added $17.3 million to the Department of Revenue’s budget for increased audit and enforcement. Additionally, President Obama’s 2010 budget added $400 million, to IRS enforcement activities.
The IRS uses a computer scoring system to determine who gets audited. The computer examines tax return inputs and determines the likelihood of a tax error. Each return is assigned a score. Those with the higher score are more likely to be selected for audit. While the specific factors to trigger an audit are kept secret, the following factors will increase your likelihood of being audited.
Tax return abnormalities – The IRS computers will examine your return and search for abnormalities. These abnormalities include high deductions as compared to your reported income. Reporting less income on your tax return than has been reported on W-2's, 1099’s, etc. (this will certainly bring about a letter from the IRS requesting more information). Reported income that is lower than others in your profession will increase the likelihood of an audit. Large variations in income from year to year might also trigger an audit.
High wage earners – Those that earn over $100,000 per year are five times more likely to be audited. The IRS knows that larger assessments are likely to come from those with more income.
Round numbers – A tax return with a lot of round numbers, i.e. a $1,000 capital gain, or $1,500 in real estate taxes look suspicious. It can be indicative of someone “guessing” at numbers and will increase the likelihood of IRS scrutiny.
High charitable contributions – The IRS believes charitable deductions are a significant abuse by tax payers. In recent years, increased donation reporting by charities has been proposed to cut down on the abuse. The IRS will scrutinize tax returns with charitable deductions that are significantly higher than others in their income range.
Business owners – The self-employed are more likely to be audited. Should your business show continuous losses over the years, the IRS may determine that your business is actually a “hobby” and deny your deduction.
Home office – Those that take a home office deduction will definitely increase the likelihood of IRS scrutiny.
Cash industries – Those employed in cash intensive industries are more likely to come under audit. Cash intensive industries include food service, salons and taxis.
The unlucky few – the IRS also conducts a small number of random audits. These audits are not necessarily triggered by tax return indicators. In 2007, the IRS completed approximately 13,000 random audits.
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