It’s the Golden State for Tax Audits
California’s higher-than-average incomes and propensity for fraud helped cement its position as the IRS’ favorite target for audits for the fifth year in a row, according to figures collected by the Transactional Records Access Clearinghouse, a nonpartisan data research organization at Syracuse University in New York.
Meanwhile, Southern California superseded Northern California to become the most-audited district. Three of the state’s four districts--Southern California, Northern California and Los Angeles County--have traded off as the nation’s most-audited since 1995.
The Southern California district, which excludes Los Angeles County, was also the toughest on low-income filers, auditing returns with incomes under $25,000 at a rate twice the national average and nearly seven times higher than districts such as Ohio and Michigan.
Los Angeles County continued to be the most stringent district for the affluent, ranking first among the Internal Revenue Service’s 33 districts in audits for incomes higher than $100,000 for the fifth straight year.
IRS officials and tax preparers blame the audit rates on a variety of factors, from big incomes to large populations of the working poor.
Californians tend to make more money and are more likely to be self-employed or run cash businesses than the national average, said Steve Jensen, director of the IRS Los Angeles district and acting director of the Southern California district. All three are areas where the agency has spotted significant misuse and abuse of tax law.
In addition to being more able than wage earners to hide income, affluent filers are also more likely to be targeted by scam artists touting tax shelters and other schemes to evade taxes, tax experts said.
The trend has only accelerated as stock-option millionaires flood the state, said Ernest Howard, a certified public accountant and chairman of the California Society of CPAs’ Hollywood-Beverly Hills chapter.
“You’ve got a bunch of newly rich people who . . . have no idea of the tax implications of all this wealth,” Howard said. “They think there must be some way to avoid taxes.”
Fraud and errors also haunt California’s large immigrant and low-income populations, according to tax experts.
Immigrants and the poor are particularly vulnerable to making mistakes and being exploited by unscrupulous tax preparers on complicated issues such as the earned income credit, a refundable tax break for low-income workers, Jensen said.
The clearinghouse’s district figures include only face-to-face audits and not the semi-automated service center exams that made up 70% of official IRS reviews in 1999. The IRS does not break down service center audits by district, but national figures show the rate of audits for low-income filers last year exceeded the rate for high-income taxpayers for the first time in recent history.
Though 73% of the IRS service center audits nationally targeted low-income workers, only 39% of the audits that originated in California’s Fresno service center were aimed at filers with incomes of less than $25,000.
The Fresno district includes Los Angeles County, Central California, Northern California and the Pacific Northwest. The low-income audit rate was 82% for the Ogden, Utah, service center, which includes the Southern California district, among others.
The IRS’ overall audit rate has dropped dramatically in recent years as the agency struggles with funding cutbacks, a smaller staff and a major reorganization prompted by scathing congressional hearings in 1997.
Audits have dropped 46% since 1996. National figures show the IRS audited just 91 out of every 10,000 taxpayers last year--the lowest level in recent history. Excluding service center audits, the rate of face-to-face exams was just 31 in 10,000.
The lack of enforcement is encouraging some taxpayers to cheat or be more aggressive in the deductions they claim, since the risk of getting caught is so low, said Paul Kuperstein, president of the California Society of CPAs and a CPA with Braverman Codron in Beverly Hills.
The IRS has no recent figures showing how much money it may be losing to taxpayer fraud, error or failure to file. The last comprehensive audits designed to measure noncompliance, done in 1988, showed the IRS could be collecting at least 10% more if taxpayers fully complied with the law. If compliance has remained unchanged, that means the IRS could have collected $180 billion more last year had all taxpayers complied with the law.
Audits declined in California districts as well in 1999. The Southern California district conducted face-to-face audits on 69 of every 10,000 taxpayers, compared with 88 of every 10,000 in 1998. The district also audited 40 of every 10,000 low-income filers.
Although reasons for the district audits were not available by income class, nearly a third of the district’s exams overall were due to secret IRS methods that flag returns based on mathematical formulas. The Southern California district has also targeted some returns for errors and fraud related to the earned income tax credit, IRS officials said.
Los Angeles County, meanwhile, had a lower-than-average audit rate for filers with incomes under $25,000, scrutinizing just 11 of every 10,000 low-incomes returns. Jensen said he could not explain the variation between the two adjoining districts.
Although these taxpayers’ income bracket was low, the additional tax bills were not. When additional taxes and penalties were assessed after a face-to-face audit, they averaged $4,522 nationally, $3,312 in Southern California and $4,302 in Los Angeles for low-income filers.
Tax bills were even heftier for those found wanting in high-income audits, with a $38,093 average assessment in Los Angeles County.
Wealthy taxpayers were far more likely to end an audit with no additional taxes owed, however. In Los Angeles County, 37% of high-income audits resulted in a draw, up from 26% in 1995. Nationally, 19% of high-income returns and 14% of all tax returns resulted in no tax change.
The rich “have the money that it takes to grind the IRS down,” said CPA Howard, who charges $250 an hour for his services. “I’ve done it myself. You build up so much resistance and there’s nothing glaringly obvious and, rather than pursue it knowing it will go to appeals, at some point they just back down.”
The poor are much easier targets, lacking both the funds and the sophistication to defend themselves in audits, said Edward J. McCaffery, a USC law professor and executive director of the USC Tax Institute.
“The whole system makes it difficult to audit rich people and that keeps pressure on poor people,” McCaffery said. “It’s a bad, vicious cycle.”
The clearinghouse figures showed several other trends:
* The self-employed were more likely to be audited than other taxpayers, although audit rates on such Schedule C taxpayers have also declined. Between 2% and 3% of the self-employed faced audits last year, depending on incomes.
* Collection activity has fallen dramatically, with levies, liens and seizures down as much as 98% in two years. The Los Angeles district seized property just three times last year, compared with 528 seizures in 1997.
Union officials representing IRS employees say the 1997 congressional hearings resulted in new guidelines for IRS staff that created confusion and led many to sharply trim their collection activity for fear of losing their jobs.
* Overall, IRS staffing today is 31% lower than in 1988, when the agency audited more than one in 10 high-income returns, clearinghouse data showed. Today the figure is about one in 100.
Many auditors were reassigned to answer IRS toll-free help lines and create taxpayer education programs in the wake of the 1997 hearings conducted by Sen. William Roth (R-Del.). The IRS was roundly criticized during the hearings for failing to answer its phones or help confused taxpayers navigate its byzantine organization systems.
IRS officials say the days of declining audits may be coming to an end. The agency’s reorganization, which will shift audit responsibility from district offices to four large divisions, is expected to be completed in October. Auditors will resume their duties and the IRS has asked Congress for more funding to beef up its staff.
Much of the clearinghouse’s data is available to the public at https://trac.syr.edu.
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Audit Central
California led the nation in the rate of IRS audits in 1999.
All 1040 and 1040A Returns
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Average Rank additional Percent in taxes per District audited nation return** Los Angeles County 0.67% 2 $10,386 Southern California* 0.69 1 7,863 Central California 0.56 4 10,015 Northern California 0.60 3 6,016 U.S. average 0.31 8,929
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* The Southern California district excludes Los Angeles County and includes Orange, San Diego, San Bernardino, Riverside and Imperial counties.
** Average taxes per return in audits where a tax change was recommended. No change was recommended in 14.1% of all U.S. audits, 22.2% of Los Angeles audits, 15.2% of Southern California audits, 20.5% of Central California audits and 17.9% of Northern California audits.
Leading Reasons for Audits
Nearly a third of all face-to-face district audits resulted from a secret IRS formula that flags returns for review based on mathematical criteria. Other leading reasons include a relationship to a return already under audit and a refusal to file a return.
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Selection reason Percent of returns audited IRS formula 29% Related to return already audited 19 Refusal to file 10 Information gathering projects 10 Suspicious tax preparer 6 Questionable refund claim 3 Taxpayer request 3
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Source: Transactional Records Access Clearinghouse, Syracuse University, New York
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Facing the Tax Man
Higher-income taxpayers still have a greater chance than lower-income filers of being called in for a face-to-face audit. Here is the breakdown for California regions by income category:
* Note: Income refers to total positive income reported before adjustments such as IRA deductions, exemptions and itemized or standard deductions. These figures reflect only district audits, which include the bulk of face-to-face audits; audits generated by IRS service centers are not broken down by district.
* The Southern California district excludes Los Angeles County and includes Orange, San Diego, San Bernardino, Riverside and Imperial counties.
** Average taxes per return in audits where a tax change was recommended. No change was recommended in 14.1% of all U.S. audits, 22.2% of Los Angeles audits, 15.2% of Southern California audits, 20.5% of Central California audits and 17.9% of Northern California audits.
Source: Transactional Records Access Clearinghouse, Syracuse University, New York
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FAIRNESS QUESTION
Low-income taxpayers faced IRS audits at a higher rate than high-income filers in 1999, raising troubling questions of fairness. A1
