TAX VERSUS RISK
There Are Two Numbers on Every Tax Return
GEORGE WILSON ADAMS CPA MBA
May 27, 2022
Double Trouble
Everyone knows that tax returns are all about taxes and people focus on the all important number: Tax. But this is a simplistic perspective that is only half true. The reality is that every tax return contains two numbers: First, the tax you owe the government, and second, an invisible number - risk. Risk is the probability the return will be audited by the IRS, or bounced by them because it contains errors or significant omissions.
Good tax preparation will always try to minimize both numbers. Search for, find, and pay the legal minimum tax while at the same time minimizing risk.
How To Minimize Risk
Risk minimization requires paying close attention not merely to what is on a tax return but also to how information is presented. Here are some key guidelines for generating a tax return that will be processed smoothly:
(1) Give the IRS only the information it requires - do not volunteer extra information or add unnecessary schedules. For example, many of my fellow accountants prepare returns that contain Form 6251 for the alternative minimum tax, even when this form is useless and not necessary for a client.
(2) Use precise numbers. Do not use numbers rounded to the nearest hundred or thousand. Some readers may know about Benford's Law, also called the Law of First Numbers. For many sets of numbers, including amounts shown in tax returns, Benford's Law states that the first digit of any number will follow approximately the following frequency distribution:
Number 1 appears as the first digit 30.1% of the time
Number 2 appears as the first digit 17.6% of the time
Number 3 appears as the first digit 12.5% of the time
Etc.
For more insight into Benford's Law see:
https://mathworld.wolfram.com/BenfordsLaw.html
(3) Fill out tax forms fully and completely in order to satisfy the Beard Test, which is a set of four criteria that determine whether or not a document filed with the IRS is respected as an actual tax return that is processible.
The definition of a tax return was developed by the United States Tax Court in Beard v. Commissioner, 82 T.C.766, 774-79 (1984), aff’d 793 F.2d 139 (6th Cir 1986). The four-part “Beard Test”, which has been accepted by nearly every federal court in the United States, states that in order for a document to qualify as a valid return:
1. It must purport to be a return;
2. It must be signed under penalty of perjury;
3. It must contain sufficient information to allow the tax to be calculated; and
4. It must represent an honest and reasonable attempt to satisfy the requirements of the tax law.
(4) Avoid math errors. Use a competent accountant or high quality tax preparation software to prevent this type of mistake.
(5) Reconcile the tax return to all documents filed with IRS, such as Forms W-2, 1099, 1098, etc.
Tax and Risk Are Inversely Related
Tax cheats may delude themselves into thinking they can save on taxes by not filing returns. Yes it's true they may have zero tax for a while. But eventually it's likely the IRS will catch up with them. What this means is that for these individuals tax is at a minimum (zero) and risk is at a maximum at time X. At a subsequent time Y risk will detonate into a devastating bill for back taxes, interest, and penalties.
Many people struggle to understand risk. Saving on taxes produces a tangible benefit: piles of cash not paid to the IRS. This is a big people-pleaser. Risk on the other hand is an abstraction and a negative.
Here is the clearest plain English definition I can give: Risk is a concept that says "Laugh now, cry later."
If you pay the legal minimum tax then your risk is zero. In this context paying the legal minimum tax is like paying for insurance - you are protected from future adverse events with the IRS.
Who Pays Federal Income Tax in the U.S?
According to 2018 data compiled from IRS sources by the National Taxpayer Union here is the truth about who pays income tax in this country:
The top 50% of taxpayers (measured by taxable income) paid 97.06% of total income taxes.
The top 25% of taxpayers paid 86.97% of total income tax.
The top 10% of taxpayers paid 71.37% of total income tax.
The top 1% of taxpayers paid 40.08% of total income tax.
The bottom 50% of all tax filers paid 2.94% of total income tax.
Source:
https://www.ntu.org/foundation/tax-page/who-pays-income-taxes
"Congress can raise taxes because it can persuade a sizable fraction of the populace that somebody else will pay."
Milton Friedman
(Awarded the 1976 Nobel Prize in Economics)
George Adams
Certified Public Accountant Master of Business Administration
Tel: (207) 989-2700 E-Mail: GeorgeAdams@IntelligenceForRent.com
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