Every year around this time, many tax payers and tax professionals express a heightened curiosity regarding the possible factors that might trigger a future IRS tax audit.
As if searching for the Holy Grail of finance, for many it seems the quest to identify and avoid the proverbial "red flags" that increase the chances of IRS scrutiny will protect them from evil, provide them with special powers and reward them with health, happiness, and prosperity in infinite abundance.
Rather than focusing exclusively on these potential "red flags", perhaps it might be wise and more instructive to consider a different more holistic perspective when tying to predict and prepare for possible future IRS behavior as represented by this red white and blue flag?
WHAT SIGNALS ARE YOU SENDING THE IRS?
Are you inadvertently telling the IRS you are looking for a fight? Inviting them to take a closer look? Are you waving a red flag or something else?
Interestingly, the origination and modern uses of the term "red flag" varies but the 1602 Oxfod English Dictionary cites its use by military forces preparing for battle. Seeking conflict if you will.
A Naval Encounter between Dutch and Spanish Warships by Cornelis Verbeeck. c. 1618/1620. A solid red flag, signifying the ship’s intent to engage in combat with a Spanish galleon (left ship), flies at the Dutch warship's stern (right ship)
Thus in keeping with the early nautical idiom, an alternative to IRS red flags, one may want to think of the nautical signal flag for the letter "W" or Whiskey. It is comprised not just of the color red, but three colors - red, white, and blue. Likewise it might serve as a convenient reminder of three elemental factors - each starting with the letter "W" that could be helpful in predicting and avoiding possible future adverse IRS actions.
And while this discussion is appropriate for every tax payer, there are certainly many affluent yacht owners wondering what they may do to avoid a proverbial future catastrophic collision course with the IRS.
Can just taking all the tax deductions you are entitled be a potential red flag to the IRS?
Many speculate and guess about the possible factors that may precipitate an initial IRS inquiry, but actually for many that's probably not even the most important question.
Research confirms that very few of the most affluent tax payers take full advantage of all of the available tax incentives and benefits Congress has included in the tax code. The evidence suggest this may be due to frequent changes in the tax code, the constantly evolving interpretation of existing regulations by the IRS and courts, and the lack of knowledge by tax professionals.
However, it is indisputable that whether correct or not, many tax payers and tax professionals believe that one's DIF score as explained by the IRS, how much a tax return differs from one's peers, plays a significant role in determining which returns the IRS reviews.
As a result, many tax payers fail to take full advantage of the benefits legitimately available for fear of being "too different" from the average and possibly attracting IRS scrutiny.
Understandably, even though tax professionals advise taking all the deductions one is entitled, many tax payers over pay their taxes- sometimes substantially- simply as the cost of convenience. For many, it's simply not worth the worry - if taking all their deductions could put them at higher risk of an IRS audit.
Perhaps the optimal solution is to take all the deductions your are entitled as Congress intended and not worry about any possible red flags that may prompt an IRS inquiry.
Rather it's wise to focus on what signals you will send the IRS after their notice.
WHO DOES THE IRS TARGET?
Well documented budget cuts have reduced available IRS enforcement resources so the total number of actual audits is relatively low by historical standards. IRS resources have not kept up with the population growth. But that is not necessarily good news for some tax payers.
The IRS is just like any person or any organization with finite resources and objectives to achieve - they seek to maximize their return on investment. They want the most bang for the buck, the low hanging fruit will be picked first. So the IRS must have a priority list.
While the rates of IRS tax audits each year may be lower than they have been in the past, one thing is clear - your chance of being audited increase with your income. In fact the IRS even has a special "Wealth Squad" called The Global High Wealth Industry Group that focuses on the most affluent.
But wealth is a relative term. Just ask anyone that has filed under the Alternative Minimum Tax (AMT) or owns a small business.
With more income often comes more complicated and sophisticated tax events and the greater the possibility of mistakes, oversights, and inadequate compliance.
Then there is the more cynical school of thought that believes that as the IRS conducts more mass mailing letter inquiries, many of the wealthier tax payers may just be willing to go ahead and pay some additional tax - whether they owe it or not since they have the extra financial resources anyway and it will not really affect their lifestyle or net worth.
It is just a cost of convenience - a burden of the affluent. Sort of like when a business settles a nuisance suit that really has no merit but it is cheaper to settle the frivolous claim than pay the attorney to fight it. Not to mention the hassle and headache.
Another highly targeted group of low hanging fruit are those tax payers that file tax returns with easily identifiable errors or that take clearly erroneous or mistaken positions or those that are especially voluminous or complicated. These returns are often target rich environments.
As complicated as the tax code has become, even using tax experts, it's easy to be wrong.
This point was recently emphasized again by now Chairman of the House Ways and Means Committee U. S. Congressman Kevin Brady's citation of the policy paper number 130 by David Keating the senior counselor of the National Taxpayers Union.
Particularly the section "Experts Agree They Can’t Agree on Tax Bills", where he reminds the reader of the Money magazine tax projects, "For many years, Money magazine’s annual test of tax professionals for a hypothetical household proved that paid professionals often make huge mistakes".
In 1998, the last year Money administered the test, all 46 tested tax professionals got a different answer, and none got it right. The professional who directed the test admitted “that his computation is not the only possible correct answer” since the tax law is so murky. The tax computed by these tax professionals ranged from $34,240 to $68,912.
Not one of the CPAs got it right. For just a minimal simple family tax return, the subject tax liability varied by a range of more than 100%. And that was just between a small sampling of just 46 CPAs.
It makes one wonder about the variance in complex tax returns, and if what one is paying is correct - or even close.
He also documents in the policy paper the situation has not improved in recent years but probably worsened.
Thus it should be no surprise the IRS sees complicated tax returns - even those filed by tax professionals - as likely to be error filled.
The last element to consider represented by the letter "W" is for the weak.
That includes the "weak" as it relates to the willingness to fight - either because they lack the financial resources to fight or they have the resources but lack the will to fight and would just rather pay more tax whether owed or not and be done with it.
Then there are the weak in the positions they take. Those that take clearly flawed, erroneous or frivolous positions.
Finally and perhaps the most insidious are tax payers weak in their documentation.
Tax payers can only take the deductions which they can prove they are allowed. A tax payer can have all the resources, the will, and be 100% correct in his tax position, BUT if he can't prove it with adequate documentation to the satisfaction of a tax court-then he is wrong- and an easy target for the IRS.
As the courts so frequently and eloquently state:
Every deduction from gross income is allowed as a matter of legislative grace, and only as there is clear provision therefor can any particular deduction be allowed, and a taxpayer seeking a deduction must be able to point to an applicable statute and show that he comes within its terms.
The taxpayer bears the burden of substantiating his claimed deductions by keeping and producing records sufficient to enable the IRS to determine the correct tax liability.
For most people, it is probably not justified to worry much about potential IRS audit red flags. Especially if one keeps in mind the nautical Whiskey signal flag - red, white and blue- flag as an easy reminder of the three W factors - the Wealthy, Wrong, and the Weak.
The chances of being audited are statistically low, but they do increase with greater income, wealth and complexity.
The wealthier you are, and the more sophisticated and complicated your tax filings - sooner or later you will probably- eventually- be asked by the IRS to document your substantial deductions and verify that your tax advisers have advised you properly.
Be prepared for it, expect it, and it should not be any big deal- if / when it happens.
Don't make clear errors or take frivolous or erroneous tax positions that are low hanging fruit.
Don't take any deductions you are not prepared to substantiate by proper documentation.
Keep this red white and blue flag in mind and you probably don't need to worry about any red flags or what other signals you might be inadvertently sending sending the IRS. You will send a clear message to the IRS - that your are prepared and that there are better uses of their limited resources and easier picikings elsewhere. Enjoy your whiskey!