In an effort to boost compliance with tax laws and regulations, the IRS recently announced it would increase the number of audits in the next fiscal year.

But the audit increase is just one component of the agency’s renewed focus on compliance.

“The IRS increasing its audits is just one piece of the puzzle,” New Haven, Conn. tax practitioner Richard S. LeVine said, noting that Congress has passed new tax shelter rules and the IRS has written new ethics rules for tax advisors.

LeVine, a partner at the firm of Withers Bergman, said the emphasis on enforcement results in part from a climate of corporate malfeasance.

Robert McKenzie, a former IRS lawyer who now defends taxpayers, said his clients have been “motivated” by the IRS’s increasing emphasis on enforcement.

“Just over 600,000 people were audited in 2001, and last year, the IRS audited 1.2 million,” said McKenzie, who practices at Arnstein & Lehr in Chicago. “The more people the IRS touches, the more people are motivated to comply.”

Michael Saltzman, a tax attorney at White & Case in New York, agreed.

“I think the Service hopes that this will change the way in which tax returns are prepared,” he said.

The agency’s work has paid off: for the fiscal year ending Sept. 30, enforcement revenues increased by 10 percent, to a record $47.3 billion.

While the IRS won’t comment on specific targets, the following will receive greater attention:

Taxpayers with incomes of $100,000 and above.

Abusive shelters, or transactions lacking an economic purpose other than avoiding taxes; in particular, shelters that involve offshore accounts.

Self-employed workers and small businesses (those with under $10 million in assets).

A March 2005 IRS study found that the “tax gap”- the difference between what the government estimates it will collect and what it actually collects – costs the government more than a quarter of a trillion dollars in lost revenue.

The IRS did not return calls requesting comment.

What to Expect

The targets that will get a closer look in the coming year were derived from the IRS study released in March.

According to Saltzman, regular wage-earners, who receive W-2s, are unlikely to produce any audit material because their taxes have already been withheld. But small businesses and the self-employed, as well as higher income earners, have a much larger potential for tax avoidance or unreported income, he said. And medium to large businesses, as well as individuals doing business as partnerships, are always a target for IRS enforcement.

“The idea is that it will be more effective to hit those target groups than try to find individual problems in the overall picture,” Saltzman explained.

The process requires a computer program that filters out the target groups after returns are filed. Audits are then performed on that smaller universe of taxpayers.

The IRS has also increased its usage of audits by mail.

McKenzie noted that mail audits can pose more problems than the traditional face-to-face audits performed by an IRS agent.

“Frankly, the people with whom I correspond [by mail] are not as well qualified as … trained IRS agents,” he said.

While IRS agents must complete a full year of training and have a certain number of accounting hours under their belts, the service center employees who handle mail audits receive more limited training, McKenzie explained.

“If they write my client and say he left his dividend income off from General Motors stock, that’s pretty simple to respond to. But when they move to some more complex issues, there can be real difficulty communicating,” he said.

The IRS has also warned that it will audit more partnerships, and target abusive tax preparers, McKenzie noted.

Tax lawyers now face the threat of sanctions under new IRS regulations that went into affect June 20.

Treasury Circular 230 – a new list of regulations governing the practice of attorneys, CPAs and other tax advisors who appear before the IRS – contains standards of practice that “micro-manage” the tax advice process, according to Saltzman.

For example, “under the Circular 230 rules, you cannot discuss in any written device what the likelihood is that your client will get audited,” LeVine noted. “So you can’t say, ‘Here’s a good tax shelter to use, because I don’t think you are going to get audited.'”

And the failure to comply can result in serious penalties – a practitioner who violates the rules is subject to monetary fines and/or suspension from practice.

A provision in the American Jobs Creation Act, signed into law on Oct. 22, 2004, allowed the IRS to enter into tax collection “contracts” with private agencies. The agency announced that it would begin implementing the program in 2005, but the plan was delayed when the losing debt collection agencies filed suit, alleging that the bidding process was flawed.

The Service re-bid the contract, and private agencies are now scheduled to begin their work in June 2006.

Saltzman expressed concern about the plan.

“While it may make sense for businesses to outsource, at the end of the day, we’re talking about a government agency which has a very sensitive function, which is to separate people from the money they earn,” he said. “And debt collection agencies are not noted for their warm and fuzzy approach to collecting unpaid debts.”

McKenzie agreed, noting that because the private companies are paid based on the amount of money they collect – up to 25 percent of what the taxpayer pays – they have an incentive to be more aggressive than an IRS agent.

“In addition, the lack of control over privacy is very different than we would see with the IRS,” he added.