What are the chances of being audited? While the IRS does not release many of the factors that it uses to identify taxpayers for tax audits, the IRS does release general statistics that can help gauge an individual’s audit potential – or can they?

Looking at the most recent IRS statistics for fiscal year 2006, the general answer is that less than 1% of individual taxpayers were audited this year. The statistics also show six times the number of higher income taxpayers were audited than lower income earners. In addition, the statistics reveal that the IRS conducted three individual tax return audits for every one business tax return audit – with partnership and Subchapter S corporations being audited the least.

The IRS statistics also show that IRS enforcement actions (such as IRS liens and IRS levies) have now exceeded pre-Revenue Restructuring Act levels (for non-tax folks, the Revenue Restructuring Act was Congress’ attempt to put the breaks on aggressive and abusive actions).

According to the statistics IRS criminal investigations have declined in the past three years, but the IRS conviction rate remains at over 90% and the average sentence is now over 20 years.

While it is nice for the IRS to provide statistics like this, I do believe that the IRS should supplement the statistics with explanations (and maybe even a footnote or two). Absent explanation the statistics are somewhat meaningless.

Take for example, the idea that higher income taxpayers were audited at a rate that is higher than lower income taxpayers. That is really meaningless because many (if not the majority) of wealthy taxpayers have little or no taxable income. Think about it this way: the taxpayer who has a $50,000,000 small business, a $5,000,000 brokerage account, and a $2,000,000 home may very well have less taxable income in any one year than the average public school teacher.

Many of the taxpayers who have over $1,000,000 in taxable income are taxpayers who have a one time windfall or other single event, because taxpayers with over $1,000,000 of income for more than one year hire tax attorneys to restructure their financial affairs so that they do not have that much taxable “income.”

If this is correct, what the IRS statistic is saying is that they prefer to audit taxpayers who have a windfall (probably because those persons do not know that they should hire a tax attorney to restructure the transaction or because it is more difficult to fully shelter that much income for taxpayers who do not have other assets – such as real estate or business interests).

Let’s think about the idea that individual taxpayers are audited more than business taxpayers. This is misleading because the majority of all business are owned by individuals. Those individuals are audited and in those individual audits, the IRS often conducts a limited review of the business in the process. This is especially true for single member LLC owners or sole proprietors who report their business earnings and expenses on their individual tax return. Unfortunately the statistics to not indicate how this issue is reflected in the IRS numbers.

With regard to the IRS enforcement and criminal investigation figures, those figures do not account for IRS errors and major changes that have occurred recently – such as the IRS practice of imposing liens and trying to levy on taxpayer assets where no tax is due (in many cases due to the tax being discharged in bankruptcy or the statute of limitations for collecting the tax having expired) or the courts overturning the criminal sentencing guidelines.