We would like to alert you to some significant changes in the way the IRS targets businesses for tax audits, and how it conducts them. When you read statistics about the percentage of returns that are audited, you might feel justified in playing the odds that your business won’t be among those selected by the IRS for scrutiny. But the numbers are very misleading, because the IRS is getting a lot smarter about how it chooses returns for audit and how its examiners conduct their audits.

Over the past few years, the IRS has dramatically stepped up its efforts to study specific industries, and to educate its examiners about business practices, terminology, accounting methods, and common industry practices. It has also identified areas of inquiry that produce audit results. Examiners are told specifically to look out for certain red flags to get at what is really going on in a business or transaction.

The result is that examinations are more sharply focused on potential areas that will generate increased taxes, penalties, and interest. Fortunately, there is a positive side to all of this. The IRS has made public a number of its Industry Specialization Program papers and Market Segment Specialization Program manuals. These help us keep up on the areas that IRS will be targeting in its audits. So far it has issued detailed audit guide information on a range of industries, from general ones, such as retailing, to more specific ones, such as law firms, restaurants, entertainment, communications and petroleum. Much more information on specific industries is expected to be issued as the IRS continues to devote resources to the development of these programs.

Another IRS initiative tries to improve compliance by meeting with representatives of various industries to work out understandings with them about specific tax problems. For example, IRS and the food service industry have come to an understanding about properly determining and reporting employee tips. Employers that comply will face reduced IRS scrutiny on this issue.

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