Every year, Americans pay millions of dollars in extra tax. Because they are concerned about or fearful of an audit, they decline to claim deductions they are fully and legally entitled to. This is the Fear Tax.
Because I write a lot about our own tax minimization efforts… (Yeah… sorry about that :/ ) I get more than my fair share of commentary in this regard:
“The IRS is coming for you, man!”
“OMG!!! You are going to get audited!!!! Ahhhhhh……!!!!!”
It’s totally worth it though, because I’ve learned a great deal and saved big dollars as a result. But also because these conversations often lead to great discussions about tax law, ethics, fairness, government accountability, and civic responsibility.
Maybe we can have another one of those helpful discussions…? This time, about the Fear Tax.
The Fear Tax
There is no reason for the IRS to be a warm and cuddly organization. A reputation for cold and callous behavior helps ensure respect and compliance. Even the language used in the law is somewhat terse and threatening:
26 U.S. Code § 7201 – Attempt to evade or defeat tax
Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.
And then there are the big news stories about famous people suffering the government’s wrath:
“Because of the IRS, Al Capone rotted in jail, suffering from syphilitic delusions!”
The syphilis probably wasn’t the fault of the IRS… but Al Capone did have millions of dollars in income that was never disclosed on tax returns. That is tax evasion. Don’t do that. (Also, don’t kill people.)
“But Pete Rose spent months in jail and had to pay $366,042.86 in back taxes and penalties!”
Sure, he intentionally and knowingly filed false tax returns. That is tax fraud. Don’t do that either.
The Dreaded Audit
What exactly is this audit thing that people are afraid of? According to the IRS itself:
An IRS audit is a review/examination of an organization’s or individual’s accounts and financial information to ensure information is reported correctly according to the tax laws and to verify the reported amount of tax is correct.
In English: people look at your tax return and see it if appears normal and makes sense.
There isn’t anything terribly concerning about having the IRS look at your tax return. After all, isn’t that why we sent it to them?
The IRS will audit a few tax returns randomly, and others that just look weird. For example, it wouldn’t make sense for somebody making $25k/year to have $100k in mortgage interest deductions.
Besides, what are the odds?
How Likely is an Audit?
The likelihood of an audit is extremely low. In the words of some guy on Forbes:
…statistically speaking, you have a better chance of being abducted by aliens or dating Taylor Swift than being audited.
I don’t want to crush the dreams of you big time T-Swift fans, but that means never. In FY’15, only 0.7% of returns were audited.
Reviewing the data by Adjusted Gross Income is even more interesting:
(Data from 2015 IRS data book.)
Low income and 1%ers are most likely to be audited. On one extreme, the IRS is probably curious how you managed to buy groceries and pay rent if you had no income last year. On the other extreme, if you made bank you probably had a complicated tax return… and these returns are likely to provide the biggest return per audit hour.
For Schedule C / E filers, the odds increase.. more complicated returns are more prone to error, but the odds are still less in the range of “once in a lifetime.”
But if you are abducted by aliens… how bad is the probing?
Penalties and Interest
I’ve been audited 3 times that I can remember. (Sorry TayTay, I’m not interested.) Each time was a minor inconvenience and a great educational opportunity.
All of my audits were Correspondence Audits (done by mail.) I received a letter asking for clarification, supporting documents, or money. I replied with the information and/or dollars requested, and that was that.
In one case, I even got an additional refund. Another time, I was asked to pay some back taxes, penalties, and interest. (Sometimes math is hard. Oops.)
Generally speaking, there are 3 main situations where penalties will be applied:
- Failure to file – you didn’t file your tax return by the due date (incidentally, if the IRS owes you money you can wait up to 3 years to file…)
- Failure to pay – you didn’t pay all tax due. This can go hand-in-hand with failure to file.
- Accuracy-related – this applies if you were negligent; disregarded the rules; made a substantial understatement; claimed a tax benefit for a transaction that lacked economic substance; or made a foreign financial understatement.
Not filing a return or filing late can result in penalties of up to 25% of tax due, although there is potential leniency for cases where there is a clear inability to pay.
Accuracy related penalties can be more severe; up to 40% of tax due. Interest charges may also apply (currently only ~3%.)
Those sound like big numbers, and they are, but note some key words that are missing… nowhere does it say “big penalties because this guy claimed deductions to which he was fully and legally entitled.”
No, penalties are for people who “don’t pay their taxes”, “don’t file their taxes”, and “do a crap job on their taxes.”
It is easy to not be one of those people.
How Much Tax To Pay?
But how much tax should we pay? What deductions are we fully and legally entitled to?
Well… all of them. They exist in law because you are expected to claim them.
OK, but isn’t trying to minimize our tax burden illegal, or maybe an ethical gray area?
It turns out the United States Supreme Court took some time out of their busy schedule to answer for us:
The legal right of an individual to decrease the amount of what would otherwise be his taxes or altogether avoid them, by means which the law permits, cannot be doubted.
That sounds very clear to me, but maybe you are looking for an answer from a higher power than the SCOTUS?
Many, many years ago, when I still owned rentals, I had a tax accountant who prepared my returns. His philosophy: “If you are not being audited, you are not taking enough deductions.”
Indeed, every year he did my taxes I was audited. Most times I had to pay a bit more, but overall far less than if we’d been less aggressive.
I was amazed at what the IRS was willing to accept even when they had us under the microscope.
If you are committing fraud, yeah the IRS is something to be feared. And, as you are shifting your burden to me, I hope they get you.
But if you are aggressively seeking every deduction you are untitled to, while you may have some quibbles to resolve, the IRS is not there to punish you.
The US Treasury received millions of extra dollars every year because people decline to claim deductions to which they are fully and legally entitled, out of fear of an audit. This is the fear tax.
US tax law and the IRS should be respected, yes. But feared, no. As long as we do our taxes in good faith, and timely and honestly report our full income, there is little to be concerned about. The stories of jail and big fines are about people who forgot that bit about honesty.
Sometimes we make innocent mistakes, and that is OK. That might result in some small penalties and interest, but over the years this will be much less than the guaranteed penalty of the Fear Tax.
So go ahead, claim those deductions. History, probability, the US Supreme Court, and the law are on your side.
NOTE: I’m just a random guy on the Internet who has no idea what he is doing. Tax laws change periodically, and you should consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice, is not a substitute for tax advice, and could just be wrong :)