Wealthy Taxpayers Draw More IRS Scrutiny

Arden Dale for the Wall St. Journal writes: The Internal Revenue Service audits the very rich more than the merely rich, and draws that line at $10 million.  Taxpayers who report $10 million or more of adjusted gross income have raised more red flags with the tax agency than other, less wealthy, filers in recent years. New data from the IRS underscores this trend. For financial advisers who work with the $10 million and over set, audits are a fact of life that must be discussed upfront. The reporting of investments, charitable contributions or sales of businesses are expected to draw greater scrutiny from the IRS.

"When we talk about these things, we talk in the context of 'Let's assume you are going be audited,'" said Michael Krol, a planner at Waldron Wealth Management, an advisory firm in Pittsburgh with $1.1 billion under management.

The 2012 IRS Data Book, published in March, said the agency audited 27.37% of individual tax returns with AGI over $10 million filed in calendar year 2011. In contrast, it audited only 8.9% of returns with AGI between $1 million and $5 million, and 3.57% with AGI between $500,000 and $1 million.

The $10 million threshold makes sense to Mark Blumenthal, a tax partner and leader of the Family Office Service Group in the Chicago office of Plante Moran, an accounting and business advisory firm.

Taxpayers who fall into that income category tend to file more complicated returns. They are likely to have a closely held business or portfolio of hedge funds, partnerships or other complicated investments as well as large deductions--increasing the likelihood of tax-return errors.

"If you want to buy CDs, even in big numbers, you won't necessarily be audited, but if it's alternative investments including private equity or hedge funds, it's not 'if,' it's 'when,'" Mr. Blumenthal said.

Form 1040, the individual tax return, can require more than 30 supporting attachments--from Schedule A for itemized deductions to Form 4562 for depreciation and amortization of business and other property, to Form 8582 to report passive losses from business. When the dollar amounts are larger, naturally the possibility of errors goes up as well.

The IRS tends to audit returns that show unusual events, like the sale of a business or a large charitable contribution.

The agency recently asked a client of Mr. Blumenthal to show proof of a big charity gift that involved investments that generated Forms K-1. These tax documents are often hard to deal with; they can run to 15 or 16 pages, and must be reported in several places on a tax return. In this case, good record-keeping impressed the IRS agent and the client didn't owe any extra tax.

Well-organized and well-documented records are the key to surviving an audit, said James H. Guarino, an accountant and certified financial planner at MFA--Moody, Famiglietti & Andronico LLP in Tewksbury, Mass.

One has to be able to prove that each item on the return was reported correctly. It is foolish to expect the IRS to accept the explanation that, say, a deduction is the same as last year, without documents to prove that, Mr. Guarino said.

Advisers say being upfront about the prospect of an audit helps clients cope when the IRS does call. But that doesn't make the process easy.

"When people get audited, they get nervous," Mr. Blumenthal said. "That's human nature."