IRS audits may not catch wealthy evading taxes on business income

WASHINGTON -- The Internal Revenue Service has been auditing more high-income taxpayers but may not be effectively going after one of the biggest problems -- wealthy people who evade taxes by reporting too little business income or overstating business expenses.

The reason is that IRS auditors most often conduct audits of high-income taxpayers by correspondence, said a report by the Treasury office. In those cases, the IRS sends letters to taxpayers asking them to verify information on their returns.

Fewer audits actually require high-income taxpayers to sit through intensive, face-to-face examinations, which could turn up more evidence of missing business income or overstated deductions for business expenses, J. Russell George, the Treasury Department's inspector general for tax administration, said in a new report.

"These types of taxpayers and issues are difficult to examine through correspondence," the inspector's report said. By their nature, audits by letter are "less complex and issues are limited" when compared with traditional audits, it added.

The IRS has increased the number of intensive face-to-face audits of wealthier taxpayers over the last few years, even though its budget has remained basically flat.

Kevin Brown, who heads the IRS small business and self-employed division, agreed that intensive audits find more unreported income. "The observation is correct," he said. "We don't think we're doing enough there, and we want to do more."

Both types of audits -- those by mail and in person -- have increased in recent years, reversing a slide in IRS tax law enforcement that started in the late 1990s.

The IRS examined 1 in 65 tax returns filed by high-income individuals and families and 2005, higher than the 1 in 116 examined in 2002. More than 5 percent of people reporting more than $1 million in income saw their returns audited last year.

The number of face-to-face exams increased by 25 percent in that time, a change that the Treasury inspector called a "significant achievement" because they are more complex and time-consuming.

Examinations by letter, however, increased 170 percent during that time. The result was that two-thirds of the audits of high-income taxpayers in 2005 were done by mail.

The IRS uses the correspondence examinations because they cost less and require less time compared with face-to-face meetings, allowing the agency to check up on more tax returns.

Brown said the average face-to-face audit takes 40 hours, compared to the 10 hours an average correspondence audit consumes.

IRS Commissioner Mark Everson has increased audits of high-income taxpayers in an effort to start closing the annual tax gap, the roughly $345 billion owed but not paid.

IRS researchers have found that the biggest contributor to the tax gap are taxpayers who don't report income from business ventures. That includes sole proprietors, independent contractors, self-employed workers and others who report business income on their individual tax returns.

Audits of high-income taxpayers reporting such income on their returns has increased, the Treasury investigators said. The IRS audited 1 in 28 such returns in 2005, an increase from the 1 in 69 examined in 2002.

But more than half, or 54 percent, of those audits were correspondence examinations done by mail, the Treasury inspectors found.

Almost 20,000 high-income taxpayers reporting business income had their returns examined through correspondence. In only 22 percent were raised questions regarding the taxpayer's business, the report found.

Business income, unlike wages paid through paychecks, does not always get reported independently to the Internal Revenue Service. That can make it more difficult for the tax agency to detect when taxpayers understate their business income on their tax returns.

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On the Net:

Treasury Inspector General for Tax Administration: http://www.treasury.gov/tigta/