Smaller Fish to Fry -- IRS Targets Self-Employed

April 9, 2010— -- Faced with a huge federal deficit and armed with better computer systems as well as a legion of newly trained auditors, the Internal Revenue Service in recent years has quietly established a new number one priority: extracting unpaid taxes from people who are self-employed.

"I have seen more audits in the past two years, and it isn't who you think that's being singled out," said Jeff Fouts, a tax attorney based in Atlanta. "Most people tend to think the IRS goes after the wealthy or famous, but actually quite the opposite is true. It's the little guy most likely to be audited."

Statistically speaking, the IRS only appears to be slightly upping its examinations of bottom-bracket taxpayers. In 2006, the IRS conducted around 1.2 million examinations of individuals who earned less than $200,000; last year, there were around 1.3 million of those types of examinations. Still, roughly 90 percent of the 1.4 million IRS audits conducted in 2009 involved persons earning under $200,000. By comparison, the IRS conducted just 28,349 examinations of individuals who earned more than $1 million.

Minding the Gap

Meanwhile, according to the IRS, the bulk of the agency's audit resources are allocated to its Small Business/Self Employment division, one of four divisions created following the IRS Restructuring and Reform Act of 1998.

Most of the IRS auditors (examiners) are housed within the SBSE division, but many of those auditors are assigned to other types of cases beyond self-employed individuals and sole proprietors.

The largest chunk of uncollected tax by far is attributable to self-employed persons. The IRS estimates that of the approximately $345 billion in annual uncollected income tax, around $150 billion is attributable to self-employed persons, or those who fill out Schedule C forms.

It is widely held misconception that the IRS tends to predominatly go after big corporations or high net worth individuals, accountants and tax attorneys said.

In 2001, the IRS launched a three-year study, part of its National Research Program, which estimated that the annual gap between what was owed the government versus what was collected was roughly $300 billion.

In 2006, the IRS revised the gross gap figure up to an estimated $345 billion while at the same time dedicating itself to narrowing the gap.

IRS Audits: Artists Beware

At least one-third of the gap reflects money for which the IRS has no reported record.

For example, in the case of a homeowner who pays a neighborhood handyman $300 to unclog the gutters, it is likely that 99 percent of the time there's no 1099 Form issued along with the check. It's then on the handyman, or gardener, or nanny or babysitter for that matter to report the income. From the IRS's research, most of it never does get reported.

"Certain aspects about the way the tax system treats self-employed persons provide opportunities for non-compliance," said Nina Olson, the National Taxpayer Advocate testifying before Congress a few years ago.

In other words, the way the reporting system is organized, regular employees have little opportunity to under, or flat-out fail, to report their income, since tax is withheld by employers. But self-employed persons have more leeway.

So what kinds of self-employed people are most likely to get audited?

"Believe it or not, a lot of the audits I see involve artists and musicians," said Shelly Jacobson Taylor, a New York City-based CPA who runs a family tax preparation firm, SJ Associates. "So the IRS sees an individual who has a Manhattan address and claims $20,000 in income. That's a red flag right there -- the IRS knows you can't live in New York City on $20,000."

Greener Pastures

But don't think urban dwellers get singled out; farmers are another group that the IRS has singled out in its research.

One IRS study found that only 23 percent of income earned by farmers actually gets reported.

Plumbers, electricians and other tradesmen, particularly within the construction industry are also seen under regular IRS scrutiny, tax attorney Faust said. Some plumbers, for example, may take in $400,000 a year but only claim $40,000 as salaried income, with the rest as a business "distribution" taxed at a lower rate. But the IRS can run numbers to see what the average plumber earns -- and because usually it's more than $40,000 this can be a red flag.

Jacobson-Taylor said the best thing for self-employed individuals to keep in mind is that audits are a very real possibility and that while people may think certain money is out of the IRS's line of sight, they need to think again; if an audit does ensue, the IRS can check bank records. And a quick check of bank deposits can allow the IRS to detect unclaimed income.

Legitimate reimbursements or gifts can be mistaken for income, Jacobson pointed out, stressing the importance of keeping good records.

Bottom line for freelancers and one-man shows: don't get too cute, experts said.

"With the IRS," Fouts said, "you are guilty until proven innocent."