Navigating the IRS: A Comprehensive Guide for High-Net-Worth Individuals

High-net-worth (HNW) individuals face increased scrutiny by the Internal Revenue Service (IRS) as part of audits aimed at ensuring compliance with tax regulations. These audits delve into various aspects of individuals’ financial activities, examining potential areas of concern.

Below are some of the IRS’s current areas of focus:

1. Reportable transactions: The IRS pays attention to many types of transactions like syndicated conservation easements and micro-captive insurance, focusing on those with abusive potential.
2. Schedule C or passthrough losses: HNW examinations often target entities with sustained losses, particularly those involving extraordinary items, such as significant bonus depreciation expense deductions.
3. Material participation: The IRS reviews the application of passive activity loss limitations and assesses whether entities within the taxpayer’s enterprise are engaged in passive activities.
4. Foreign-source income and assets: Examination includes scrutiny of foreign financial accounts, with a focus on addressing non-compliance related to foreign bank accounting reports and other offshore disclosure and income reporting forms.
5. Private foundations: The use of private foundations is examined, and careful attention is given to self-dealing issues, related-party transactions, contributions to non-public charities, and trustee and employee compensation.
6. Charitable contributions: Substantiation and valuation of charitable contributions, as well as those related to conservation easements, are closely examined to combat excessive donation deductions.
7. Meals and entertainment: The IRS investigates whether claimed expenses for meals and entertainment are directly related to the taxpayer’s trade or business and are ordinary and necessary.
8. Business versus personal expenses: Entities with assets like aircraft, boats, or vehicles are scrutinized to determine if they are available for the personal use of the HNW individual, and inquiries are made regarding real property or leased properties subject to personal use.
9. Related-party transactions: Concern around the complexity of pass-through structures and the potential for circular flows in closely held enterprises can lead to inquiries about contracts, agreements, or transactions between related parties.
10. Gifts and bequests: The IRS will investigate large gifts or bequests to ensure proper reporting requirements are met, also focusing on valuation for non-cash transfers.

Knowing the scrutiny of these key areas and being prepared for an IRS examination is crucial for HNW taxpayers. Effectively resolving an IRS examination for HNW individuals hinges on substantiation. Therefore, it is imperative for taxpayers to have comprehensive documentation supporting their tax reporting positions. This includes federal tax returns, schedule K-1 forms, organizational charts, bank account information, receipts and invoices for material expenses, and other relevant documents. Being prepared with this information can significantly contribute to a smoother resolution of an IRS audit.

For more information on the IRS’ enforcement efforts, see our previous client alert. If you have questions about the updates or need assistance related to the IRS’ enforcement efforts, please contact Alan Goldenberg, Principal and Leader of the Tax Controversy and State and Local Taxation groups, or your Anchin Relationship Partner.