How the IRS thinks and works

This page is based mostly on my own first-hand experience from almost ten years of working in the USA. I ran several companies there myself, set up a good number of companies for clients and worked closely with US entrepreneurs, whom I in turn helped gain a foothold in Europe.

It gives you a good look at how the IRS works, but it is certainly not meant as an empirical study. Others will have had different experiences. But since my situation matches that of many clients (Europeans who start a company in the USA), I hope my impressions carry some weight in this particular context.

Ever since the IRS cracked down hard on Swiss banks and ultimately dealt the deathblow to the famous (or infamous) Swiss banking secrecy, we have known one thing: these guys don't mess around.

Most Europeans are used to a fairly demanding tax office at home. But you do get the impression that the Americans go about it a notch harder and more ruthlessly.

So quite a few business owners wonder whether doing business in the USA puts them halfway to prison. What happens if I make a mistake on my tax return because I don't yet fully understand how things work in the US? What happens if I get bad advice? What happens if I miss a deadline because I had no idea a return was due?

Questions upon questions. Here I share my own experiences with you, and I hope they give you a realistic picture of the IRS.

1The big picture in numbers

Every year, 250 million tax returns are filed with the IRS. 160 million of them are income tax returns from employees and the self-employed. Around 8 million corporations file a return. 30 million are payroll tax returns from employers.

For 70% of all income tax returns filed, the IRS issues a refund check.

One in 104 returns (so less than 1%) undergoes a detailed audit. For the self-employed, the odds of a closer look are 1 in 47. If you earn a million dollars or more a year, your odds of landing in the IRS's sights are 1 in 34.

If you report no self-employment income and earn less than $200,000 a year, your odds of being audited are just 1 in 272.

The vast majority of audits (72%) are handled by mail. Only very rarely do auditors actually show up in person.

Every dollar invested in audits brings the government four dollars in extra revenue. Most of that comes from small and mid-sized businesses. Even so, the IRS budget keeps getting cut. As a result, 100,000 fewer returns were audited in 2014 than in 2013.

That forces the IRS to focus even harder on the targets that pay off most: those small businesses. The share of corporations being audited keeps falling.

The US has no VAT with monthly or quarterly reporting of detailed business sales. So the annual tax returns are the IRS's main way of getting income and sales information from taxpayers.

The IRS has three years after a return is filed to audit it, or six years if the return leaves out income of more than 25% of the reported gross income. For tax fraud or returns never filed, however, there is no time limit: the IRS can audit and assess indefinitely.

2Tax honesty in America

In my experience, tax honesty among Americans is not exactly stellar. Working off the books is practically a national sport. Even "public servants" such as soldiers and police officers join in without a second thought when there are a few extra dollars to be made.

Then there are around fifteen million undocumented immigrants in the USA who can only work off the books anyway. Above all in border towns, but also in cities like New York, they find low-paid work in restaurants, on farms and in other businesses that need manual labor.

But the problem is far from limited to "lower" income groups. I know at least two attorneys in the US who failed to properly report cash income for years. Both were reported by employees they had let go.

In general, it's completely normal for a great many Americans to have a side job to boost their income. You see this across every social class and profession: teachers who tutor, bankers who broker mortgages on the side, police officers who work security at private events. Some of it adds up to very healthy sums, sometimes more than the main job. And it's all paid in cash, off the books.

Wherever a big company is involved, though, you can assume everything is handled more or less by the book. So people who rent out their home on Airbnb or drive for Uber have no chance of escaping the taxman. Here, so-called 1099 forms go to the IRS once a year, reporting how much was paid to independent contractors.

3The IRS strategy: shock and awe

Most Americans are completely relaxed about the IRS and don't even make much of an effort to hide or conceal untaxed income. People here are utterly unfazed.

And as the statistics above show, the sheer volume of data makes it almost impossible to catch at least the "small" tax cheats, especially the clever ones.  

That's why the IRS comes down really hard on the ones it does catch. "Shock and awe" is the motto. The idea is to make an example of them, a genuine deterrent. Celebrities, who clearly have a high profile, tend to get especially rough treatment. The IRS rather enjoys playing Robin Hood here.

Campaigns like the one against the Swiss banks are also about deterrence, alongside the huge revenue such measures "generate". A zero-tolerance approach is promoted to keep taxpayers at home in line. The aim is to spread fear among anyone who isn't honest about their taxes.

Remember, too, that more than half the population pays no income tax at all. So the government wants to be especially thorough with the remaining net payers, and above all the "big earners".

For all the saber-rattling, my actual experience is that most Americans and American companies very rarely, if ever, deal with the IRS. You certainly can't say the IRS constantly harasses people and businesses. Even a mega-agency like the IRS simply couldn't manage that.

4Dealing with the IRS as a business owner

As a business owner, you normally deal with the IRS once a quarter, when you file Form 941 for payroll taxes. It reports the total wages plus the social security due and the tax withheld for the past quarter. The amounts themselves are paid monthly.

It is absolutely essential that Form 941 is always filed on time and that the monthly payments to the IRS go out by the deadline.

Deadlines are taken very seriously, and extensions are not allowed as such. On top of that, the IRS is pretty quick off the mark when it comes to levying bank accounts.

When in doubt, it's better to file an incorrect return and adjust the figures on the next quarterly return than not to file at all.

The same goes for the annual tax return and the estimated corporate tax payments during the year (if you expect a profit).

Follow these two rules and chances are you won't hear from the IRS for years and may never be audited, especially if you don't live in the USA yourself and the company is taxed as a corporation.

What draws the IRS's attention and makes contact more likely is anything that deviates from the norm and looks a bit fishy. For example:

• Large loans to management
• If the business makes losses several years running
• Large cash transactions
• Disproportionate figures (revenue: $100,000, travel expenses: $50,000. Or: revenue: $50,000, charitable donations: $10,000)
• Real estate losses

Certain industries are also under general suspicion, such as used car dealers.

5If the IRS does get in touch

If for any reason you need to speak with the IRS, in my experience it's best to keep the following in mind from the start:

• The agent's knowledge is extremely limited.
• The agent has never been abroad and may never have left their home state.
• The agent knows their procedures inside out. They use specific terminology. They have a specific view of the world.
• There's no point trying to communicate outside the agent's vocabulary and frame of reference.

Go into the conversation with this in mind and adapt how you come across, and you'll be amazed how quickly you reach an agreement.

If there's a more serious problem you can't solve yourself, bringing in a specialized attorney is usually very wise. For an overview of the tax system, see our page on the US tax system and tax law; all tax topics are collected in our Taxes hub, and when it really counts, there's our US tax consultation.

In short

• This page draws on first-hand experience from almost ten years of working in the USA and is not meant as an empirical study.
• Only a small share of returns are audited, and most audits are done by mail. Those who get caught are made an example of.
• For business owners, what matters most is filing Form 941 on time and paying by the deadline. Filing a return beats filing none.
• Anything out of the ordinary draws attention, such as large loans to management, years of losses or lots of cash transactions.
• When talking to the IRS, it helps to meet the agent on their own terms. For serious problems, you need a specialized attorney.

How we help you

• IRS letters and penaltiesMail from the IRS? We reply, request penalty relief and put things right.
• PayrollPayroll, payroll taxes and filings for your employees in the USA.
• Corporation tax returnForm 1120 and Form 5472 for your US corporation.
• US Tax ConsultationYour US tax question, answered by people who know both sides.