Worried the IRS will audit you? If you make less than $400K, here’s one reason you can relax

Ahead of the bill’s passage, Treasury Secretary Janet Yellen pledged that there would be no increase in the rate of audits for households and small businesses earning below $400,000 “relative to historical levels.”

But Republican critics and other observers have asked what “historical levels” might actually mean.

The audit rate on returns for tax year 2018 is the reference point to remember, IRS Commissioner Danny Werfel told senators on Wednesday. He emphasized that “there’s no surge coming for workers, retirees and others.”

The IRS audited fewer than 1% of 2018 returns between $1 and $500,000, according to statistics that the tax agency released last week. The agency has three years to start an audit from the time it receives a return.

Also read: The IRS wants more people working in tax enforcement. Now it has to find them.

The numbers show that 0.4% of returns for taxpayers earning up to $25,000 were audited. That figure was 0.3% for returns between $200,000 and $500,000 and more than 9% for returns over $10 million, the IRS statistics show. Six years earlier, more than 13% of returns over $10 million were getting scrutinized, according to the IRS.

“Help us with understanding what the words ‘historic level’ means,” Sen. James Lankford, a Republican from Oklahoma, asked Werfel during a Wednesday budget hearing.

“We will take the most recent final audit rate, and it’s historically low … and we allow that to be the marker for least several years, and then we’re revisit it,” Werfel said. The 2018 audit rates were the newest final rates, he added.

“So the 2018 number is what it’s going to be?” Lankford asked.

“Yes,” Werfel replied.

“Werfel’s explanation that 2018 audit levels will be the reference point is the most detail I’ve heard so far,” Erica York, s senior economist at the Tax Foundation, told MarketWatch. “He did seem to leave open the possibility of revisiting the reference year for ‘historical’ in the future,” she added.

Another open question has been how the $400,000 income threshold will be determined. Months after the Inflation Reduction Act passed, IRS and Treasury officials still hadn’t finalized what counted as $400,000 in income, according to a January Treasury Department watchdog report.

“How are you arriving at this number?” asked Sen. Marsha Blackburn, a Republican from Tennessee. Blackburn’s state has many self-employed entrepreneurs who might appear richer on paper than they actually are, she said. “While they may have a higher gross, their net is very low,” she added.

“We’re going to look at total positive income as our metric,” Werfel said. He later added that “there would be no increased likelihood of an audit if they have less than $400,000 in total positive income.”

The IRS says total positive income is generally “the sum of all positive amounts shown for the various sources of income reported on an individual income tax return and, thus, excludes losses.” In other words, it’s a tally of income before taxpayers subtract losses.

Total positive income is a measurement method the IRS usually applies to categorize audits, the Tax Foundation’s York noted. But one challenge of strict thresholds for more audits, she said, “is that it creates incentives for underreporting income” to stay under the line.

Compared with recent years, there are now more specifics about how the IRS will implement additional audits of higher-income taxpayers, said Janet Holtzblatt, a senior fellow at the Tax Policy Center. “But still there are questions,” she noted, about how the agency will treat situations when taxpayers don’t give the full picture about their income.

Also read: Make sure the tax breaks you’re taking now won’t hammer you in retirement

And: ‘This was a test’: IRS has handled more than 100 million returns already — Tax Day by the numbers