High-income returns often involve pass-through businesses, investment transactions, foreign holdings, and large deductions. This overview explains how the IRS selects returns for examination, which parts of the IRS handle high-wealth and large business taxpayers, what an examination involves, and the steps that reduce penalty exposure.
How Returns Are Selected
According to the IRS, it uses several selection methods. One is random selection and computer screening, in which returns are compared against “norms” for similar returns developed from audits of a statistically valid random sample under the IRS National Research Program. Another is related examinations: a return may be selected because it involves issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected.
Examination rates also vary by income. The IRS Data Book reports that for tax year 2021, examinations covered 0.3 percent of all individual returns but 6.6 percent of returns reporting total positive income of $10 million or more. See our article on IRS audit rates for high-income returns for more detail on these figures.
Who Handles High-Income and Large Business Cases
The IRS Large Business and International (LB&I) division is responsible for businesses with a U.S. tax reporting requirement and assets of $10 million or more, as well as the Global High Wealth and International Individual Compliance programs. LB&I practice areas study compliance issues and recommend “campaigns” for its compliance plan. Owners of closely held businesses may therefore see examinations that look at the individual return together with related partnerships, S corporations, trusts, or foreign entities.
What an Examination Involves
The IRS states that it begins audits by mail, not by telephone. An audit may be conducted by mail or in person, either at an IRS office or at the taxpayer’s home, business, or representative’s office. The IRS generally can include returns filed within the last three years and, if it identifies a substantial error, may add years, though it usually does not go back more than six.
The assessment statute of limitations is generally three years after a return was due or filed, whichever is later. The IRS may ask a taxpayer to extend it. A taxpayer does not have to agree, but the IRS notes that the auditor will then make a determination based on the information provided. Taxpayers have the right to appeal disagreements within the IRS and in the courts, as described in Publication 1, Your Rights as a Taxpayer.
When a Civil Matter Becomes Criminal
IRS Criminal Investigation (CI) investigates alleged criminal violations of the tax laws and refers its findings to the Department of Justice for recommended prosecution. According to the IRS, criminal investigations can begin when a revenue agent, revenue officer, or investigative analyst detects possible fraud, or from information received from the public or other law enforcement agencies. Criminal tax cases require proof of willfulness, which is discussed in our article on IRS criminal tax investigations.
Complexity, not wealth alone, is what makes many high-income returns harder to examine and to defend. Clear records for valuations, related-party transactions, and entity-level items make any examination more manageable.
Reducing Penalty Exposure
Accuracy-related penalty: under §6662, a 20 percent penalty can apply to an underpayment attributable to negligence, a substantial understatement of income tax, and certain other categories. No penalty applies to a portion of an underpayment for which the taxpayer shows reasonable cause and good faith (§6664(c)).
Disclosure: according to the Form 8275 instructions, adequate disclosure of a position with a reasonable basis can avoid the portions of the accuracy-related penalty due to disregard of rules or a substantial understatement of income tax for non-tax shelter items. Disclosure does not avoid the penalty for negligence, for substantial understatements on tax shelter items, or for transactions lacking economic substance. Positions contrary to a regulation are disclosed on Form 8275-R.
Reportable transactions: listed transactions, confidential transactions, transactions with contractual protection, certain loss transactions, and transactions of interest must be disclosed on Form 8886. Under §6707A, failing to disclose a reportable transaction carries a penalty of 75 percent of the resulting tax decrease, with a minimum of $5,000 for individuals and a maximum for individuals of $10,000 ($100,000 for a listed transaction).
Records and privilege: the IRS requires taxpayers to keep the records used to prepare a return for at least three years from filing, and longer records are often needed for basis and carryover items. Communications with a lawyer for legal advice are generally protected by the attorney-client privilege. The separate federal privilege for CPAs and enrolled agents under §7525 is limited to noncriminal tax matters before the IRS and noncriminal federal tax proceedings.
The Bottom Line
High-income taxpayers are examined at higher rates than other taxpayers, and their examinations often extend to related entities and transactions. Understanding how returns are selected, keeping well-organized records, and using disclosure where appropriate are the most reliable ways to limit the cost of an examination.
Facing an IRS examination?
Tax attorney Cassra Minai, Esq. can review your situation in a confidential consultation.