Image: Tom Daschle
David Zalubowski  /  AP file
Tom Daschle is the latest high-profile American caught not paying all his taxes. But even 'ordinary' citizens are vulnerable to getting tripped up by the complexities of the tax code.
By John W. Schoen Senior producer
msnbc.com
updated 2/5/2009 10:39:22 AM ET 2009-02-05T15:39:22

In owning up to the mistake of nominating former Sen. Tom Daschle for his Cabinet — in spite of known problems with his tax returns — President Obama said it was important to stress that “there aren’t two sets of rules, one for prominent people and one for ordinary folks who have to pay their taxes.”

There may be one set of rules, but there's different levels of scrutiny. Prominent people, or at least those nominated for high profile government jobs, face a level of inquiry that most taxpayers don’t have to worry about.

Still, no matter how hard “ordinary” taxpayers try to get it right, they're vulnerable to getting tripped up by the extraordinary complexities of the tax code.

“Our tax laws are complex,” said Diahann Lassus, a certified public accountant and chair of the National Association of Personal Financial Advisors. “Certainly if someone went through most individual tax returns over the last 10 years, the odds are pretty good they could find something. In most cases probably small, but they could find something.”

In the latest fiscal year, the IRS examined only 1 percent of all individual returns. The more money you make, the higher the odds the Tax Man will take a closer look. Last year, the IRS examined about 3 percent of returns for filers with income of $200,000 or more; the rate for those with income of $1 million or more was 5.6 percent.

The same holds true for business returns; the IRS examines a much higher percentage of returns from large companies than it does for small businesses.

You’re also more likely to face scrutiny if your return looks unusual compared to other people in your tax bracket. One of the tools the IRS uses to determine who to audit is a computer screen that compares the line items in your returns against similar returns in your tax bracket. If you’re claiming much bigger charitable deductions than others at your income level, for example, that could be a red flag.

When the IRS does find mistakes, a lot depends on what they are. The most common are the basics: filling in the right Social Security number, math errors, etc. Those are fairly easy to catch.

Next on the list are deductions, the part of tax preparation many filers pay the most attention to. No one wants to pay more tax than they must, but the IRS pays as much attention to deductions as you do. If you claim one you don’t qualify for, you’ll be on the hook for extra taxes and possible penalties if the IRS successfully challenges it. You don’t have to take their word; if there’s a lot of money involved, you can always challenge their ruling in court.

But the mistakes that tripped up Daschle — along with Treasury Secretary Tim Geithner, who won his nomination, and Nancy Killefer, who withdrew as a nominee for as a key White House aide — were among the most serious. These involve failing to report income and not paying the full amount of tax owed on that income.

Those mistakes don’t usually get very far when made by “ordinary” taxpayers with mostly wage income.

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“For the average person everything they have as income has been reported to the IRS,” said Tom Ochsenschlager, vice president of taxation at the American Institute of Certified Public Accountants. “If you don’t report that on your tax return you’ll get a notice back from the IRS' computer in a matter of days after they get your return.”

People who make a living as freelancers, consultants, or independent contractors with multiple clients are at greater risk. If you earn more than $600 from any one employer or client, that payment is supposed to be tracked by a 1099 form sent to both you and the IRS.

“Sometimes you may not receive them, but that doesn’t mean the work you performed isn’t taxable,” said Gil Charvey, an analyst with the Tax Institute at H&R Block.

Killefer’s nomination got derailed by another common slip-up known as the “Zoe Baird problem,”  named for the Clinton administration‘s first nominee for Attorney General who ran afoul of the IRS for not paying the proper taxes on a household worker. Baby-sitter problems turned out to be so widespread, it also sank Clinton’s second nominee, Kimba Wood, two weeks later.

Since then, the IRS has attempted to simplify the process of paying taxes for household workers by incorporating those taxes directly onto the main 1040 return (line 60) which directs you to file a Schedule H. Anyone who paid more than $1600 to any one household worker is required to fill out the form and pay the appropriate taxes. But that still won’t take care of the similar filling required by most states; each state requires you to fill out a separate set of forms.

Geithner, who in his new job now runs the IRS, was grilled during his nomination hearing for failing to pay taxes related to income paid by a foreign employer. Though he accepted full responsibility for the error, he noted that he relied on TurboTax, a popular tax prep software package, to help determine what he owed.

The IRS, however, doesn’t care who or what caused a mistake. Any error on your return, even if you’re relying on an accountant to do your taxes for you, is your responsibility. Though accountants say the IRS may cut you some slack if your preparer takes the blame, nominees to higher office are usually held to a higher standard.

“There are a lot of mistakes that can be made with taxes,” said Lassus “The bigger question for most of these guys is: How long did it take to discover the issue and who discovered it? Was it their adviser? Was it them was it an outside person investigating them?”

Taxpayers, of course, aren’t the only ones who make mistakes; inevitably the folks down at the IRS make mistakes of their own.

Last year, the Treasury Dept.'s Inspector General for Tax Administration did a study of the accuracy of the IRS Automated Underreporting Program. This is the computer system used to match up forms and filings from employers, banks brokerages and other third parties to make sure all income is reported correctly. The system typically catches mistakes on over a million returns.

The study found that, while most of the notices generated by the computers are correct, some taxpayers were “negatively affected by inaccurate information on the notices.”  So it pays to pay as much attention to those IRS notices as it does to filling out your original return.

This is an updated version of a story that originally appeared Jan. 5, 2009.

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