The IRS has endured significant budget cuts in recent years. And in today's political landscape, with continuing pressure on lawmakers to reduce federal budget deficits, even more cuts might be coming. Nonetheless, the IRS appears as committed as ever to examining individuals, particularly those of high net worth. Moreover, thanks to the efforts of the IRS's Global High Wealth Industry group (GHW), an IRS exam is likely to be broader in scope, more time-consuming, and more invasive than ever before. Given these recent trends, taxpayers may wish to take a renewed look at whether they are truly examination-ready.
Background
In past decades, when an individual was audited by the IRS, the exam focused on the individual. It was led by examiners specializing only in individual income tax, most likely from the IRS's Small Business/Self-Employed Division. Increasingly, however, the Service has realized that, to gain an accurate picture of a taxpayer's complete income and wealth, it must take a more holistic approach, examining not only the face of the Form 1040, U.S. Individual Income Tax Return, but also the partnerships, S corporations, foreign investments, royalty and licensing agreements, private foundations, and trusts that the taxpayer may control.
One result of this holistic focus is GHW, which was formed in 2010. GHW, which is part of the Large Business and International (LB&I) Division, seeks to make several key improvements to the old way of auditing personal income tax returns. First, the group consists of a broad group of experts, including not only individual tax specialists, but also corporate, partnership, and international experts, economists, and appraisers. As such, the group can better understand the various aspects of a taxpayer's wealth. Moreover, the group uses more-sophisticated methods to perform its risk assessment and to determine the scope of the exam. For example, it electronically matches Social Security and/or employer identification numbers to connect related entities. Hence, the IRS can identify any entity that is associated with an individual's Social Security number (e.g., the individual is a partner of a partnership, etc.) and may consider including those entities as part of its examination of the individual.
Initially, GHW's progress was slow, and its presence was not keenly felt by taxpayers or practitioners. In the past year or two, however, the group has gained momentum. Consider, for example, that taxpayers reporting adjusted gross income (AGI) of between $5 million and $10 million saw their audit rate increase by 9 percentage points from 2014 to 2015. And taxpayers reporting AGI of more than $10 million saw their audit rate increase by 18 percentage points, to over 34%. Furthermore, taxpayers who have been selected for an audit have seen the information document requests steadily increasing in length and scope, often requesting information about closely held businesses, trusts, and other investment ventures.
Recent Areas of Focus
Certain target areas have been the subject of increased focus of IRS examinations. Charitable contributions, a longtime target during examinations, have been even more closely scrutinized lately, with an increased look at valuations. IRS inspection of losses from passthrough activities has intensified as well, particularly over whether there was a risk of loss (i.e., the at-risk rules of Sec. 465), whether there was sufficient profit motive in the activity (i.e., the hobby-loss rules of Sec. 183), and whether the taxpayer was active in the business (i.e., the material participation rules of Sec. 469). Significant foreign activity is also sure to interest the IRS, particularly the presence of significant foreign tax credits and/or foreign bank accounts. Use of a corporate airplane is highly likely to be scrutinized in an examination. Each of these areas of increased focus reflects the new holistic thinking of GHW and is the result of the more varied range of specialties that auditors are bringing to the examination, as well as the different entities they are examining at once.
Being Exam-Ready
Regardless of the aforementioned focus areas, certain themes have become increasingly apparent in recent years, and some universal recommendations for being exam-ready have emerged. First, the required record retention is often more significant than taxpayers expect. Take, for example, the task of proving one's basis in a partnership. Many taxpayers or practitioners rely on a basis-tracking worksheet maintained in their tax preparation software. Others might maintain a separate roll-forward showing year-by-year changes in basis. Although such calculations are helpful, the IRS often requires more. For example, to establish contributions to a partnership, the IRS has determined that basis roll-forwards, Schedules K-1, or even the partnership agreement is insufficient. Instead, actual check copies or other bank records proving the cash was actually transferred into the partnership have been required.
Furthermore, the expiration of the statute of limitation does not relieve the taxpayer of the responsibility to prove basis from the beginning of the investment. Often, taxpayers discard their tax returns and all related supporting paperwork after the statute of limitation has expired (generally, three years after filing). However, certain items should be retained indefinitely. For example, taxpayers should retain, in a separate file, any documentation establishing basis, including Schedules K-1, bank statements, check copies, etc.
Second, when it comes to supporting documentation, contemporaneous documentation is key. "Contemporaneous" appears throughout case law and IRS manuals. It refers to documentation that is collected in real time, as the activity occurs, rather than re-created later. The assumption is that documentation that is timely is more accurate, and because it is not re-created as a result of a looming or ongoing audit, it is more trustworthy. To establish business mileage, for example, a travel log should be maintained and updated each day while traveling, rather than at the end of the year. Similarly, to demonstrate active participation in an activity, taxpayers should update calendars, time reports, or logs daily (or at least weekly) to reflect time spent on an activity.
For charitable contributions, a contemporaneous written acknowledgment of the donation is specifically defined by the Code as being a letter from the charity received before the return is filed. Taxpayers should be sure to ask the charity for those letters and to ensure that the letters include the required language that "no goods or services" were provided to the taxpayer in exchange for the donation. For showing business losses are not hobby losses, an area in which profit motive is critical, the act of maintaining daily records is itself an indicator of that profit motive. (Most taxpayers would not maintain daily records for mere hobbies.)
Third—and this may sound simplistic—the documentation must be accurate. If documentation is exaggerated or unrealistic, the IRS may not respect it. Take, for example, the recent case of Escalante, T.C. Summ. 2015-47. The taxpayer was trying to establish that he spent more than half of the year as a real estate professional, thereby entitling him to otherwise passive losses under the Sec. 469 material-participation rules. To support his claim, he submitted detailed logs of his time spent on the rental properties. What bothered the court, however, was the exaggerated amounts of time he allegedly spent doing routine tasks. His check-writing activities, for example, took at least an hour per check. And, on certain days, his total logged time performing real estate work exceeded 24 hours. As a result of these exaggerations, the court found that the daily logs were not credible and disallowed the losses completely. Arguably, the taxpayer would have had more success if his records were accurate and realistic, even if that meant less time was spent on the rentals.
Finally, do not be afraid to seek help. CPAs can perform an audit-readiness assessment, help identify areas of risk, and implement strategies to maintain proper documentation.
Conclusion
Although GHW's efforts were slow initially, they appear to be gaining momentum. And with its new holistic approach to auditing individuals, virtually any aspect of a taxpayer's activities is fair game for examination. Hence, being more aware of examination risks and improving one's recordkeeping habits, with an eye always on contemporaneous and accurate documentation, will go a long way toward being prepared for an IRS examination.
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EditorNotes
Alex Brosseau is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.
For additional information about these items, contact Mr. Brosseau at 202-661-4532 or abrosseau@deloitte.com.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.
