The number of face-to-face audits for high-income individuals (as opposed to computer-generated correspondence audits that are by nature fairly superficial) rose just slightly for the 2003 tax year, to four audits per 1,000 returns up from 3.8 audits per 1,000 in 2002, according to figures from the Transactional Records Access Clearinghouse at Syracuse University. Corporate audit rates fell over the same period. Currently the chance of an affluent individual being audited is about 1 in 68, according to the IRS, but the agency also reports having collected a record $43 billion in unpaid taxes through audits of wealthy taxpayers over the past year. While the Bush administration remains adamant about the idea of stimulating economic growth by cutting taxes, the government also appears to be serious about collecting money due from taxpayers who have been overly assertive when it comes to claiming deductions.

“I cannot imagine the IRS being more aggressive or hostile to tax avoidance than under the Bush administration,” says George Gerachis, a partner at the Houston law firm of Vinson & Elkins, which specializes in international tax planning. “A lot of people think that the Bush administration is soft on taxes because it wants a lower rate, but it’s been incredibly aggressive in pursuing audits and not settling in abusive cases.” In order to put fraudulent investors and advisors on notice, the Senate last fall passed legislation that enacts stiffer consequences for not disclosing tax-avoiding transactions, increases the number of penalties imposed, and tacks on additional interest charges, making it more expensive than ever to “save money” by dodging taxes.

TOP VIEW With the IRS calling for a crackdown on high-income scofflaws, and individual audits on the rise, taxpayers have been put on notice. Even traditional tax shelters, such as executive loans and offshore investments, can now raise red flags. But some wonder if the IRS has the resources to enforce its take-no-prisoners rhetoric.

Still, in spite of all the clamor, some question whether the IRS will have the funding necessary to pursue the chase. “The politicians will say they’re getting the money they need, but from what I’ve seen, they don’t really have the resources,” says Jere Doyle, senior director of Mellon’s Private Wealth Management group. “To do a good job, they need more money.” Although the IRS received a budget increase this year, much of the funding is going toward higher overhead costs, such as pay raises, which are not related to increasing the number of audits or collecting back taxes.

What seems likely is that the IRS will concentrate on certain practices that give it well-grounded cases. The Government Accountability Office figures that it missed out on tax revenues of $13.4 billion per year over the last 10 years because of known abusive shelters. The IRS Restructuring and Reform Act of 1998 effectively shifted the burden of proof in court proceedings to the IRS and away from the taxpayer, forcing the U.S. Treasury to back off, to a certain extent; consequently taxpayers became more aggressive. During this period, the popularity of a number of shelters that were initially created for Internet barons exploded. Fostering this growth, lawyers and accountants endorsed many shelters. Doyle argues that they accepted commissions like salespeople, rather than acting as independent councils.

For every listed (IRS lingo for illegal) tax shelter, there are any possible number of transactions that land in a murky area, seeming to bend, rather than break, the law. Some of these are referred to as “reportable transactions,” or deals that share characteristics with listed transactions, but which the government has not identified as such. Taxpayers are required to disclose such transactions on annual returns, and let the IRS determine their legality. “You have to file with the Office of Tax Shelter Analysis,” says Mel Warshaw, a wealth advisor with JP Morgan Private Bank in New England. “When you have to file, that’s a red flag for the IRS.” Sometimes, of course, a reportable transaction is only as solid as the tax attorney hired to defend against an IRS volley.

To date, the IRS has identified 30 illegal tax shelters; one of the most notorious is Son of Boss, which creates a counterfeit loss to offset gains. In one variation of this complex transaction, a taxpayer contributes stock options to a partnership, and although the individual actually has zero equity in the partnership, some argue that his stake equals the worth of the options. The investor then “sells” his partnership interest for zero dollars, writing off the cost of the options as a loss.