No doubt you are aware there has been considerable press about the United States Government and President’s unfavorability abroad due to the US intervention in Iraq to protect the well being of the world. One can infer the US military is one of the most feared agencies under the President’s command. However what does not receive much press and is perhaps THE most feared agency is the Internal Revenue Service. The president has decided to use its most feared, and many would say, powerful agency to protect the United States from what the President, has labeled the “Great threat to the nation’s viability”: the Gap between what the government estimates it should have collected in taxes and what it actually collected.

We are referring to the same government that estimated what it would take to safeguard the nation during Hurricane Katrina. Ask New Orleans how well they managed the aftermath of that natural disaster. This is the same government that estimated we would need a few months and a few hundred billion dollars to turn around Iraq.

Now, US taxpayers, who are funding all of those other errors, can now learn what it is like to feel the full force of the US’ most feared and hated agency of the executive branch that carries out the President’s directive. And again, we are not referring to the military, but the IRS. For the IRS is out to get you, and me and every other taxpayer in its relentless pursuit to secure the missing revenues it calculated the taxpayers are not paying the government!

Back in 1997 a Republican Congress during the Clinton Administration held hearings to review abuses by the Internal Revenue Service. Congress tied the IRS’ budget to better behavior and the IRS’s enforcement activities declined severely after Congress held hearings in 1997 on alleged abuses and passed the 1998 IRS Reform and Restructuring Act (RRA ‘98). Those days will seem like the good ole days as the government in its new form looks towards the weary taxpayer to fund the misguided decisions that have accumulated over the years.

If you are skeptical, we invite you to think again. In the latest statement from the Commissioner of the Internal Revenue Service (IRS), Mark Everson, the IRS touted its FY 2006 results. The agency is looking to build up its reputation as something to be feared. We at Colman Knight, thought you would appreciate learning what the IRS is thinking and where they are concentrating resources:  The IRS recently reported that it collected a record $48.7 billion in revenue in Fiscal Year (FY) from audit and enforcement activities. This huge amount still only represents 16% of the GAP of $300 billion annually that the IRS is looking to close and what the agency discussed to receive new appropriations. That having been said, the collection reported is the highest level in ten years and a 3% increase over 2005, so much for the kindler gentler IRS of the Reagan and Clinton eras. The amount has the following breakout: $28.2 billion from collection, $17.2billion from examinations and $3.3 billion from document matching. We want you to know that enforcement revenue has increased every year since FY 1999, when revenue was $32.9 billion.

So the IRS is looking for easy pickings and it has set its sights on individual taxpayers. The service defines various groups of taxpayers that it is auditing as follows. Total audits of individuals increased six percent, from 1.21 million to 1.29 million. Face-to-face audits of individuals increased overall by more than 20 percent, from 247,000 to 303,000, and within every income category. According to the IRS, its audits of higher-income individuals increased dramatically:

• Audits of individuals with incomes of $1 million or more increased by almost 33 percent, from 12,800 to 17,000, one out of every 16 taxpayers. This is a new category for tracking enforcement levels. We suspect politically there are very few voters in this group and recording many audits will help the IRS in its ever growing need for bigger budgets. The IRS will start to target this group and eventually this category will become the new high income group of the future (more than 5 years away).

The interesting numbers in this audit mess is that currently the IRS defines high income taxpayers as those with Adjusted Gross earnings of $100,000 or more. Total audits of individuals with income of $100,000 or more increased by 18 percent to 257,000, the highest number in 10 years. Of course, the amount also includes the taxpayers who earn $1 million and more whose audits increased by 4,200 individuals. Overall coverage of this category increased from 1.57 percent in FY 2005 to 1.67 percent, the highest rate of coverage since FY 1998, but still less than the 2.74 percent coverage in FY 1997.

It is hard to believe but the Commissioner feels that the group (which according to the Congressional Budget Office 2006 report pays 85% of all income taxes) is having a problem with compliance (read: paying enough taxes) seems ludicrous. To quote the commissioner: “lf you’re earning that kind of money and we notice a problem, you’re going to hear from us.” Then Everson decided to use the budget issue blaming lack of funds for more audits and after prodding stated that audit rates in many instances are still too low but the commissioner urged Congress to provide funds for IRS modernization, which he said is an important tool of its enforcement efforts. Everson said that the use of “infrastructure” and analysis will be more important to future enforcement activity than staffing.

The IRS did not increase audits to one group that per an earlier report represented about 1/3 of the budget shortfall ($100 billion) and that group is large corporations. The one group best equipped to fight an IRS audit. Audits of large corporations ($10 million and over) declined slightly. The IRS broke out these figures by audit class.

• Audits increased for corporations with $11 -5O million in assets from 3,535 to 4,218. The IRS audited  one of every seven corporations in this class.

• The IRS audited one of every seven corporations with assets from $50 million to $100 million and  $100 million to 1,250 million, although the number of audits dropped in both categories. Audits of the largest corporations ($250 million and higher) declined from 4,859 to 4,289, and audit coverage declined from 44.1 percent to 35.3 percent. Here is the smallest group to audit with $100 billion in annual shortfalls and yet, the audits declined, while all other groups had increases. Audits of small corporations (under $10 million) held steady at 17,871. Coverage was 0.80 percent of the 2.23 million returns flied, a substantial increase from the 7.294 audits in FY 2004. However, audits in FY 1997 covered 2.22 percent of returns filed.

Everson noted that the handling of large corporations is in transition. Audits will be less of a factor as the IRS expands its Compliance Assurance Program, which will focus on analysis of corporate activities before returns are filed. The IRS is making other changes in the audit of large corporations, such as the use of limited focus examinations, and is seeking to “get current” in corporate audits.

The least able to protect themselves, Schedule C businesses are the target of added IRS scrutiny. Here comes a fine tooth comb.

Unincorporated “Schedule C” businesses

The IRS has begun to turn its focus to unincorporated “Schedule C” businesses, which, based on studies, have only a 50 percent compliance rate. This underreporting also comprises a major portion of the $345 billion tax gap. The IRS used the same study and found that high income individuals had too few changes upon audit so it ordered its auditors to find changes. This position has resulted in non cash contributions (such as clothing to Good Will) to be targeted so that the change rate by the IRS can increase which results in favorable statistics. With Schedule C businesses, if the hit is not so large, the company gives in and produces a change and favorable statistics.

Everson said that this area is a priority and promises audits will increase. He said that Congress could help compliance efforts by enacting legislation to require third parties, such as credit card companies, to report payments made to unincorporated businesses. If a business’s reported income does not square with the amounts paid through credit card companies, the IRS will be able to recognize the problem and take compliance action. The IRS is looking to banks to assist them in their audit collection. The banks assisted the IRS with catching foreign earned income not reported in a major initiative a few years back and this is a similar plan.

Another area that for many years was safe and the IRS is now reviewing for future audit growth is pass-through entities, another source of potential noncompliance. Audits of partnerships and S corps increased over 20 percent. The second phase of the IRS’s compliance study, the National Research Program, will focus on pass-through entities. Despite this growth, the overall FY 2006 audit coverage of pass-throughs was only 0.37 percent, a 60 percent drop-off from the audit coverage before 1999.

Tax-exempt organizations are another priority for the IRS. Audits of tax-exempt organizations increased by more than 40 percent in FY 2006, from 4,900 to 7,000, although this was below the 1998 level of 10,000 audits. The IRS is boosting its presence in the tax-exempt community through the use of compliance contacts, surveys and questionnaires that focus on credit counseling organizations, charity work by hospitals, and executive compensation paid by exempt organizations.

Just what everyone wants to hear, liens and levies were up substantially from FY 2005 and reached the highest level in 10 years. Levies increased from 2.7 million in FY 2005 to 3.7 million in FY 2006 and liens increased from 523,000 to 630,000. Property seizures increased to 590 in FY 2006, the highest level since FY 1999, but still are well below the 10,090 seizures in FY 1997. Enforcement staffing showed a slight increase from FY 2005, a total of 21,000 collection officers, auditors, and criminal investigators. The IRS has hired 600 new enforcement staff, although many of these will replace experienced staffers who have retired. The agency’s enforcement staffing level is the highest since FY 1999 but less than its 25,000 enforcement staff in FY 1997. A silver lining here, a real small one, criminal actions dropped slightly. Prosecution recommendations for tax crimes declined by 7 percent, to 1,343, while illegal crime recommendations increased by 16 percent, to 756. The overall conviction rate remained at 91.5 percent, and the average sentence was 22 months, the same as FY 2005.

Given all of this, what does it mean for you and your tax preparation? It means that you should expect greater scrutiny of tax deductions. More tax audits and expenses and a more aggressive IRS looking for deductions to deny. We think the most important part is that both parties (Democrats and Republicans) are looking to the IRS to assist in minimizing the budget deficit on the back of the weary taxpayer. This is the same position the IRS was asked to take during the Great Society and the abuses during that era were so great that eventually a special law was passed to protect taxpayers. The law still exists on the books, but the enforcers of the law no longer appear to be obeying it!