As our clients know, we spend a lot of time talking about income taxes. No, we’re not masochists, we just know that for most people, and especially for retired folks, income tax planning is one of the best ways to keep more of your money. Consistent and thoughtful income tax planning done year after year can add hundreds of thousands of dollars to your net worth over time.
So, we spend a lot of time thinking about how to legally reduce income tax. We review tax returns, run tax projections, and work closely with CPAs and tax preparers to help achieve this.
One of the questions we always get when talking about tax planning opportunities is: “But wait, will this generate an audit?” And while we want to take advantage of all the legal opportunities we have to save money on taxes, we also don’t want our clients to face the fear, anxiety, and hassle that going through a tax audit may cost.
Nobody wants to raise a red flag with the IRS and have them combing through all of their financial records and invading their personal lives, right?
So with that in mind, I thought the article in the Wall Street Journal last week was helpful. It reconfirmed some of the things that we’ve been talking to clients about for years.
Chance of an Audit
First of all, the chance of anyone getting audited is very low from a purely statistical standpoint. The article reports that in the last year the IRS audited just over one million individual returns, which is only about 0.7% of the returns it received. In addition, the number of audits is getting lower and lower due to a continuing budget crisis at the IRS. Audits were down 16% from the previous year, and the lowest they have been for over 10 years.
However, it’s important to note that some folks are more likely to get audited than others. Yes, you guessed it, upper-income taxpayers generally have a much higher chance of getting audited.
Here are the stats:
However, it’s also important to note that these rates are much lower than they used to be. In 2011, before the IRS budget cuts had really taken their full force, about 12.5% of returns with incomes over $1 million were audited. The article elaborates:
Focusing on the wealthy isn’t new. After all, that’s where the money is. Also, as a report in 2015 by the Treasury Inspector General for Tax Administration pointed out, high-income taxpayers “are frequently involved in complex entities and financial arrangements that provide greater opportunities for aggressive tax planning.”
While I might take issue with the Treasury Inspector’s terminology–by “aggressive tax planning,” I assume he means illegal tax schemes, which we too would obviously want to avoid–his point is well taken. Higher income folks are, in general, more likely to fall prey to unscrupulous sales tactics for some of these illegal tax shelters, and that’s why working with a fee-only fiduciary financial advisor is so important. But to go even further, we work closely with ethical tax professionals to make sure we steer far away from the line and to keep the risk of audit as low as possible.
Living in the electronic age means that the IRS is collecting more data on people than they may realize. By law, financial institutions are typically required to report tax-related activity in your account to the IRS, and therefore, they are able to “double-check” your return against 1099s and other tax forms provided by the financial institution.
IRS computers routinely search for discrepancies between what taxpayers report on their tax returns and what is reported separately to the government by employers, financial institutions and other “third-party providers.” The IRS also looks for returns that didn’t report taxable income.
Therefore, before you hit “send” to submit your return, double-check to see if the numbers on your return match those on the relevant tax forms. This is one of the easiest ways to stay out of the IRS’s crosshairs–simply realize that much of the information that you receive on a W-2, 1099, or other tax forms, is also reported direct to the IRS. And keep in mind that no physical person has to manually check these; computers can work behind the scenes to match up the numbers and flag returns that have obvious inconsistencies.
Schedule C’s and the Benefits of Incorporation
If you are a W-2 employee, there are strict limits to the amount of legal tax planning available to you. Beyond company benefits programs and the normal set of deductions available to all taxpayers, there is a limit to the choices you can make to lower your tax bill. Small business owners, on the other hand, have more options available.
However, because most small business owners do not have company payroll departments calculating and withholding taxes on a frequent basis, the IRS has a much more watchful gaze pointed in their direction. This is especially true for unincorporated businesses, who report their income on a Schedule C.
IRS research has shown the largest amounts of noncompliance typically come from returns of taxpayers who own their own businesses, deal in large amounts of cash, receive payments that aren’t subject to tax-withholding requirements and whose income isn’t reported separately to the IRS by third parties. Auditors often zero in on filers of Schedule C, or, “Profit or Loss From Business.” Compliance tends to be much higher when there is withholding, third-party reporting or both.
For this and other reasons, we often recommend that small business owners incorporate their businesses. This allows them to take advantage of legal tax planning opportunities while also having taxes withheld from payroll and therefore lowering this IRS audit risk factor.
Smart income tax planning plays a key role in maximizing your wealth, and a thoughtful long-term strategy combines the desire to lower taxes with a healthy respect for the law and those that enforce it. Having a Personal CFO on your side, one who knows your situation, the relevant tax planning opportunities, and is absolutely 100% working on your behalf (i.e. not a salesman) is critical for long-term wealth maximization.