Ronald Regan has been quoted as stating, “The taxpayer is someone who works for the federal government but doesn’t have to take the Civil Service examination.” As a taxpayer and a tax attorney, I often get asked about why the IRS enforces tax audits – and not just from curious, young law students who may have yet to enjoy the privilege of paying taxes.
The Examination Division of the Internal Revenue Service is responsible for auditing federal tax returns to determine if income, expenses, and credits are reported accurately. This division is a branch of our federal government that is often imagined to be an invasive, scary entity.
The people who work for the IRS aren’t “government goons,” for the most part – although I have met a couple who might be described along those lines. They are very analytical people, mostly experienced CPAs who provide a service to the government. They take their jobs very seriously.
The Tax Gap and IRS Audits
You may have heard about the “tax gap.” The federal government expects a certain amount of income from its taxpayers (today, that’s you and me and approximately 141 million other people) every year.
The gap is the difference between this expected amount of income from our tax returns and what it actually collects. The estimates take into account federal taxes due as well as refundable and non-refundable tax credits.
In order to close the gap, the IRS examines a certain percentage of the income tax returns it receives on April 15 every year. It uses a statistical body of data points in the examination. Although the IRS accepts most tax returns when filed, there are circumstances that warrant an audit, based on this system of data points.
The relationship that your return has to those data points dictates how likely you are to get audited. If red flags come up, those returns are then manually checked. Those that show suspicious activity upon the manual examination are usually selected for an audit.
Within this context, the IRS is motivated to evaluate those areas of a tax return that fail to comply with current policies and provisions. In general, this motivation falls under multiple categories.
The IRS Evaluation Categories
First, the IRS is motivated to audit returns for the purpose of finding unreported income. In conducting both random and strategic audits, the “IRS has taken a renewed interest in finding unreported income” (Kane, p. 4).
The IRS examines a taxpayer’s lifestyle to determine if income has been reported properly. For example, agents may use Form 4822 to determine how much a taxpayer spends annually for the purpose of comparing amounts to what the taxpayer reports on the return.
If the agent is compelled to prepare a “cash T,” which represents a simple source and application of funds analysis, then the agent will pursue options that include questioning the taxpayer and indirect methods.
Second, the IRS Examination Division is motivated to audit returns to ensure customer service goals are met. These goals are specific to applying the provisions of the Taxpayer Act.
In 1998, the Taxpayer Bill of Rights III mandated changes in the type of customer service solutions the IRS must provide to both taxpayers and audited taxpayers. The IRS is motivated to ensure that the Taxpayer Act is implemented correctly and efficiently.
Third, the IRS Examination Division is motivated to audit returns of businesses in specific industries.
For example, when it comes to conducting audits for a particular industry, the IRS gathers information about an industry for the purpose of creating an average profile. “Actual returns will then be compared against the profile to help find compliance problems” (Kane, p. 5, 5/21/2013). The IRS then issues guidelines, between 40 and 90 to date.
In Bob Kane’s article titled “What is the IRS Examination Division Up To Today (October 19, 1998),” he suggests that “[a]udit coverage has dropped off considerably from the mid-1970s when it was at the 2.59% level overall, to the 1.38% level of today” (Kane, p.1, 5/21/2013).
However, the IRS is still motivated to evaluate particular industries. “The construction and fishing industries are two constant areas of scrutiny by the local IRS office. The IRS locally also has been focusing on mobile cart vendors, Laundromats, car dealers, bed and breakfasts, and businesses involved with freight forwarding, import/export businesses, and storage and transportation businesses” (Kane, p. 4, 5/21/2013).
Lastly, the IRS is concerned about an additional area, namely employee/independent contractor audits because it represents a huge revenue loss. The IRS cannot collect payroll taxes from independent contractors. In addition, because there are issues with audits in this area, agents have received considerable training specific to worker misclassification.
For example, the IRS unveiled the Classification Settlement Program, giving employers the option of settling cases where they have misclassified workers at reduced assessments.
Tax attorney, Bob Kane, comments on this, stating, “To obtain the reduced assessments, the taxpayer must agree to treat the workers as employees in the future. The assessments vary between 25 and 100 percent of the tax liability for one year, depending upon the taxpayer’s level of compliance with the Section 530 requirements” (Kane, p. 6, 5/21/2013).
The Small Business Job Protection Act (1996) modified Section 530, thereby changing the worker classification. The changes shift the burden of proof to the IRS “if the taxpayer establishes prima facie, (which means evidence sufficient to establish a fact or raise a presumption unless disproved or rebutted a reasonable basis) for having not treated workers as employees” (Kane, p. 6, 5/21/2013). Employee training (IRS) within this area will increase the number of compliance incidences.
What Is the Purpose of a Tax Audit?
Motivations around IRS audits tend to reveal much about the purpose of each type of audit and the overall strategy of the Internal Revenue Service.
By learning more about the motivations behind an IRS audit, taxpayers can hopefully avoid facing the scrutiny of the IRS. And who knows? You could also experience that rarity of a satisfyingly decent income tax refund.
If you would like to know more about IRS audits, please read my other writings, available at: https://www.sambrotman.com/category/irs-audits-and-examination. If you’d like to consult with me about an IRS audit or any other tax issue that you may have, simply give me a call at Brotman Law, (619) 330-9579.
 Form 4822, Statement of Annual Personal and Family Expenses
 The 1998 Tax Act is formally referred to as the Internal Revenue Service Restructuring and Reform Act of 1998. It is known as the Taxpayer Bill of Rights III (Pub.L. 105-206, 112 Stat. 685, enacted July 22, 1998).
 Robert M. Kane, Jr. is a civil tax attorney with LeSourd & Patten, P.S. Attorneys at Law. Kane handles tax dispute resolution, tax litigation, and administrative appeals. Kane graduated with a J.D. from Gonzaga University School of Law and with an LLM from New York University. For more information or to view his profile, visit: http://www.lesourd.com/attorneys/robert_kane.
 Section 530 of the Revenue Act of 1978