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This year's IRS audits are bad news — for the rich

The IRS is turning up the heat on taxpayers. Some of them, anyway.The number of audits conducted by the Internal Revenue Service has dropped as it continues to reel from years of budget cuts.

But even as its workforce shrinks, the agency must keep the money flowing into the U.S. Treasury. The solution in 2017? Focus on target-rich environments, and squeeze more dollars out of each audit.

That means more scrutiny of people and companies who are likeliest to hide money or under-report their tax burden. Tax specialists are warning their clients, especially if they're wealthy or have complicated tax situations, to be ready to hand over a lot more information. "My clients are concerned," said Debra Estrem, managing director of the tax controversy group at Deloitte.

The IRS has revealed only a few details about its plan of attack-too much information can give tax evaders clues, after all. But as head of the Deloitte division overseeing responses to hundreds of large, complex audits every year, Estrem has a better idea than most about what the IRS is up to.

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While the IRS launches fewer full-blown audits, she noticed the agency sending out more "mass notices" addressing specific issues. For example, if you reported an especially large charitable contribution on your 1040 form, IRS computers may send you an automated notice asking you for proof.

Her list of the IRS' "favorite issues" is a long one: In addition to charitable contributions, she's seen more notices about large losses, mortgage interest deductions, and 529 college savings plans. So-called "hobby losses" are a frequent IRS target. That's when people claim "losses" for business ventures that, in the IRS's eyes, were never meant to make a profit. Think of otherwise wealthy people claiming losses for musical groups, raising horses, racing cars or yachts, and even dog grooming, and you'll get the picture.

That notice in the mail is a sort of "audit lite," Estrem said. Provide solid substantiation of your credit or deduction-like a business plan for your alleged hobby-and the IRS may then leave you alone. If not, expect to hear from an agent. "The best practice is to respond promptly and thoroughly, so it will hopefully end there," she said.

Sure, any taxpayer with a suspicious-looking charitable donation may get some extra mail from the IRS. But the clues Estrem cites all point to the new reality of this year's tax season: The agency's real firepower is now being aimed at the ultra-wealthy and large companies.

For several years, the IRS has been running a "Wealth Squad," formally known as the Global High Wealth Industry Group, comprising a group of agents specially trained to pore over the finances of the very rich. They don't just examine a loaded person's 1040, but also any companies or investments he or she owns. 

Even as the IRS workforce has shrunk in recent years, the agency has found other ways to get aggressive. Along with other federal agencies, it has forced banks in tax havens such as Switzerland to disclose more about Americans' investments, and it's tried harder to connect the dots between rich individuals and their sometimes-vast networks of global wealth.

Now the IRS has a strategy focused on large companies and the very wealthy people who own them. The Large Business and International Division, which includes the Wealth Squad, announced in January that it is launching 13 new "campaigns" focusing on particular areas in which the IRS suspects it can bring in additional revenue.

The "goal is to improve return selection, identify issues representing a risk of non-compliance, and make the greatest use of limited resources," the IRS said in a statement. Groups of specially trained experts will focus on these tax issues wherever they pop up. Some of the campaigns will be very narrow-looking at energy tax credits, for example, or the way that housing developers do their accounting. 

Other campaigns could end up netting a wide variety of well-off taxpayers. One looks at "repatriation," when taxpayers move money from abroad back to the U.S. The IRS is also focusing on so-called "basket options," transactions structured in a way to reduce tax bills. The IRS said it will address some issues by first sending out letters warning taxpayers that their maneuvers may get extra scrutiny. For other campaigns, the agency said its main weapon will be full-blown audits.

Tax experts are scrambling to interpret the IRS' public statements and get taxpayers prepared. "My clients are noting what these issues are," Estrem said. "To the extent they have these issues, they're getting ready for an IRS inquiry." Big companies and the ultra-wealthy should be prepared for "more invasive and larger" audits than they've seen in the past, she added. "The IRS," she said, "is upping its game."

The agency's new strategy could end up forcing taxpayers to be less creative about how they lower their tax bills. But any federal revenue gains from such defensive conservatism could be undercut by the overall drop in audits. Last year, according to preliminary data, the IRS audited just 0.7 percent of the 147 million individual income tax returns filed. Audits fell for all income groups. 

It's not yet clear how the new Republican administration could change the IRS's plans. Tax collection is supposed to be immune from politics. But President Donald Trump is free to replace IRS Commissioner John Koskinen, whose term expires in November. Koskinen's time in office has been marked by fierce criticism from Congressional Republicans, some of whom tried to impeach him for allegedly impeding their probe into whether conservative non-profits were improperly targeted by the agency.

When it comes to tax collection under Trump, who said he's been the subject of many an audit, "it's unclear what the priorities might be," said Indiana University professor and economist Bradley Heim. "You have to wait and see who he appoints."

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