Worried about an IRS audit? Don't be

Given the publicity over the hundreds of billions of income tax revenue lost because of underreported personal and business income, no wonder the IRS has a process for detecting such deceit.

When the IRS suspects a taxpayer is failing to report a significant amount of income, it's typically determined during a face-to-face examination or a field audit. This is where IRS agents look at a taxpayer's specific situation in detail to determine whether all income is being reported.

What's surprising is that while the tax gap has nearly doubled in the past 14 years, the percentage of audited tax returns has declined. Even Captain Obvious can see that as the number of IRS audit falls, the amount of tax cheating rises.

IRS audits used to be far more common. In 1963, about 5.6% of taxpayers had their returns audited. Back then, almost everyone knew someone who had been audited.

Today, the IRS audits less than 1 percent of returns. And it conduct the overwhelming majority of these audits by correspondence. This is when IRS computers detect an income reporting error, where W-2s or 1099s don't match the income entered on the return. Letters are sent notifying the tax filer of the proposed error, and the taxpayers can respond by mail, pay the missing tax and close the matter.

So, a very small proportion of all audits are actual field audits.

But if your income is above average, your chance of an audit can rise. Here's a breakdown of the percentage of audited individual tax returns sorted by adjusted gross income:

  • $100,000 and less: 0.82% or less
  • $100,000 - $200,000: 1%
  • $200,000 - $500,000: 2.66%
  • $500,000 - $1 million: 5.32%
  • $1 million - $5 million: 5.38%
  • $5 million - $10 million: 20.75%
  • Over $10 million: 29.93%

Several reasons account for the decline in audit levels. While the IRS workload has increased, its workforce has declined. At the same time, the agency has been slammed by Congress over targeting of political groups. Add that to changes in the tax code (the biggest one being Obamacare) and fraud and identity theft. It's as if the IRS is in the midst of a perfect storm of controversy and attacks, internally and externally.

At the moment, it appears that the government's ability to collect taxes is based largely on the consent of law-abiding citizens. It's doubtful that the fear of enforcement via an audit carries the weight it once did.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.