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IRS: Maui communities are most likely for audit, tax cheats

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    FILE - This March 22, 2013 file photo shows the exterior of the Internal Revenue Service building in Washington. Worried the Internal Revenue Service might target you for an audit? You probably should worry if you own a small business in one of the wealthy suburbs of Los Angeles. Or if you?re a small business owner in one of dozens of communities near San Francisco, Houston, Atlanta or Washington. The IRS uses a secret computer program to identify potential tax cheats for audits, and researchers with access to the data say they have found large clusters of likely cheaters in these five metropolitan areas. (AP Photo/Susan Walsh, File)
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The communities in Hawaii where you would most likely find tax cheats and audits are Lahaina and Kahului on Maui, according to a study by the National Taxpayer Advocate.

The study used confidential IRS data to show large clusters of potential tax cheats. The IRS uses the data to target taxpayers for audits.

Many of the communities identified by the study are wealthy, including Beverly Hills and Newport Beach in California. Others are more middle class.

The study focused on small-business owners — sole proprietorships, to be specific — because they have more opportunity than the typical individual to cheat on their taxes. Many small businesses deal in cash while most individuals get paid in wages that are reported to the IRS.

The IRS only audits about 1 percent of tax returns each year, so the agency tries to pick returns that are most likely to yield additional tax money.

The study also looked at tax compliance in different industries, and found that people who own construction companies or real estate rental firms may be more likely to fudge their taxes than business owners in other fields.

The IRS will not say much about how agents choose their targets. But as millions of procrastinators scramble to meet Monday’s deadline to file their taxes, the agency is running every tax return through a confidential computer program to determine the chances of collecting more money from an audit.

Each tax return is assigned a score. The higher your score, the more likely you are to get audited because, according to the IRS, the more likely you are cheating on your taxes.

The score is called the Discriminant Inventory Function, or DIF. A high DIF score does not guarantee you are a tax cheat but the IRS claims it’s reliable.

“If your return is selected because of a high score under the DIF system, the potential is high that an examination of your return will result in a change to your income tax liability,” says an IRS publication that explains the auditing process.

“If you’re reporting $8,000 of charitable contributions when you’re only making $50,000, that’s a red flag,” said Bob Meighan, vice president of TurboTax, an online tax preparation service. “Likewise if you’re reporting business or employee expenses that are out of the ordinary for your income range, that would attract the interest of the IRS as well.”

The bottom line, according to the experts: People who take unusually large deductions for their income get a high score. Also, business owners who claim unusually large expenses for the size and type of their business get a high score.

DIF scores can vary across industry, according to the study by the taxpayer advocate, an independent agency within the IRS. For example, people who owned construction and real estate rental companies were more likely to have high scores. Lawyers, accountants and architects and people who provided other professional services were more likely to have low scores.

The study, which was included in the taxpayer advocate’s annual report to Congress in January, used data from 2009 tax returns to plot the DIF scores for sole proprietorships across the country. The city where you live is not a component of the score, according to the study. Nevertheless, researchers were able to identify clusters of likely tax cheats.

Sole proprietorships make up about two-thirds of all U.S. businesses. Sole proprietors report business income on their individual tax returns and, the IRS says, they account for the biggest share of the tax gap, which is the difference between what taxpayers owe each year under the law and what they actually pay.

The tax gap was $345 billion in 2006, according the latest IRS estimate.

In all, researchers identified clusters of potential tax cheats in more than 350 communities in 24 states, mostly cities and towns but some neighborhoods, too. About one-third of them were in California, with most near Los Angeles and San Francisco. Lahaina and Kahului are the only Hawaii communities on the list.

Online: National Taxpayer Advocate study: http://tinyurl.com/cjtgpt5

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