Determined to stop a distressing rise in tax fraud, the IRS is scrutinizing more returns, closing down tax shelters and dragging violators into court.

Should you worry about being audited?

If you're a middle-income wage earner with a straightforward tax return, then the answer is probably "no." But should you be wealthy, self-employed or have your returns prepared by an unorthodox tax adviser, then you’d better be sure to keep good records, because there is a chance that the IRS will want to chat with you.

The IRS Commissioner, Mark Everson, has been touring the country this past year, informing journalists, politicians and tax professionals that the tax police are back in force. Last year, the number of audits rose 19%, and audits of high-income taxpayers rose 40%. In February, noted telecommunications entrepreneur Walter Anderson was indicted by both the Justice Department and the IRS allegedly failing to pay $200 million in federal and local taxes. To date, this is the largest criminal tax case against an individual.

With federal budget deficits on the rise, there are powerful incentives to toughen tax enforcement. Last month, the IRS released a study that estimates that the "tax gap", which is the difference between the amount taxpayers owe and the amount actually paid, is between $312 billion to $353 billion a year.

However, the study also found that workers having less taxes withheld from their paychecks are the least likely to cheat. Less than 1.5% of wages and salaries subject to third-party reporting or withholding are incorrectly reported, the study found.

Among the likely candidates for an IRS audit:

Wealthy taxpayers with big losses on their returns. The IRS has launched a major assault on tax shelters marketed to wealthy taxpayers. It has collected more than $3.2 billion from the "Son of Boss" shelter, which used currency options and other financial products to create fictitious losses. Those who participated in the shelter used the losses to avoid paying taxes on sales of stock options or business assets.

According to the IRS, the amounts collected from individual taxpayers who bought into the shelters ranged from $1 million to over $100 million.

These shelters were created because tax professionals believed they could get away with it, says Scott Michel, partner with Caplin & Drysdale. Michel also predicted that tax professionals will be much less likely to recommend aggressive tax-avoidance strategies.

Tax experts are saying there is a probability that more tax-shelter cases are in the works. "The people who should be most concerned are those who entered into transactions that sounded too good to be true," says David Sands, who is chairman of the New York State Society of CPAs' IRS tax committee.

Unscrupulous tax preparers and their clients. Both the IRS and the Justice Department are aggressively pursuing tax preparers using fictitious deductions and other scams in order to inflate their clients' refunds. The IRS obtained 117 criminal convictions of tax preparers in fiscal 2004, up from 67 in 2003.

In January, the IRS issued a press release that included names of preparers convicted of filing false tax returns. "I don't recall seeing them do that before," says Mel Schwarz, federal tax director for accounting firm Grant Thornton.

A tax preparer's conviction can have far-reaching consequences. Typically, the IRS will go back and review all returns that were filed by the preparer's clients. Those individuals are liable for interest and penalties on unpaid taxes, which sometime go for back years.

And unlike tax shelters, these clients aren't always wealthy. A frequent source of tax-preparer fraud is the earned income tax credit, designed to help the working poor. Unscrupulous preparers have urged taxpayers to hide income or invent fictitious dependents to inflate the size of their credits.

More than 70% of taxpayers who claim the earned income credit use tax preparers, yet they're audited at a higher rate than others, says Janet Spragens, a law professor at American University in Washington, D.C. Spragens says many non-English-speaking taxpayers seek out preparers who speak their language, without bothering to check their credentials or training. Testifying at a recent IRS oversight board hearing, Spragens said: "The advice they get from these preparers can range from excellent to incompetent to totally fraudulent,"

The self-employed. Close to 9.5 million workers were self-employed in 2004, a 22% increase from a decade earlier. The number of self-employed workers and independent contractors is expected to keep growing as companies seek to reduce benefit costs associated with full-time employees. However, unlike wage-earners, the self-employed are responsible for reporting their income to the IRS. The IRS study found that under reported income accounted for 80% of the tax gap.

Taxpayers filing a Schedule C, the form used to report profits and losses from a business, should expect more scrutiny from the IRS. In 2005, the IRS expects to audit 207,000 Schedule C returns, up 50% since 2002

The IRS is paying more attention to the status of independent contractors, by using complicated test to determine whether an individual is a contractor or employee. If it determines an individual isn’t properly classified, the employer could face steep penalties and back taxes, while the worker loses valuable self-employment deductions.

And yet, for all its talk about chasing down the culprits, the IRS enforcement initiative faces obstacles. First among them is money.

President Bush's 2006 budget requested over $500 million in order to strengthen the IRS enforcement program. This figure might sound impressive but, according to a former head of the IRS, it's not enough. This proposed increase, like previous budget hikes, will probably be used up by congressionally mandated pay raises for federal employees.

Perplexity. Beefing up enforcement efforts will require the IRS to enforce tax laws that are becoming increasingly difficult for law-abiding taxpayers to obey.

Eric Delore of Alameda, Calif., owes the IRS more than $400,000. Delore didn't participate in a tax shelter or invent illegal deductions for a home-based business. Delore is in debt because he received incentive stock options from his former employer. And these options pushed him into the nightmare world of the alternative minimum tax (AMT).

The AMT was created to prevent wealthy individuals from using loopholes in order to avoid paying taxes, but it's increasingly affecting middle-income taxpayers. Taxpayers living in high-tax states or receiving incentive stock options are particularly vulnerable.

In 2000, Delore exercised stock options worth $1.1 million, holding on to them so he could get a better tax rate when he sold. But his employer's stock price imploded when the tech bubble burst. By the time Delore sold his shares, they were worth $5,000. But because the AMT values stock options at the time of exercise, Delore was hit with a $420,000 tax bill.

In 2001, Delore's employer filed for bankruptcy, and he lost his job. Delore now works for a software company, but his struggles with the IRS continue. The IRS has cleaned out his bank accounts and his paycheck has been intercepted. He has a lien on his house. Twice, Delore has tried to negotiate a lower tax bill with the IRS but he has been rejected both times. If the IRS rejects his latest offer, Delore, who is married with two small children, says he'll be forced to file for bankruptcy protection.

President Bush has named a bipartisan tax panel to study tax simplification. But, in the meantime, the number of taxpayers subject to the AMT continues to grow. More than 3 million will pay it this year.

Delore now realizes that he took a big risk when he told the IRS that he exercised his options. He says horror stories like his may encourage taxpayers to break the law. The government "should make compliance easier," he says. "Then you'll get more people paying their taxes."

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