IRS AUDIT MATTERS – THE AUDIT LOTTERY
For fiscal year ended September 30, 2015 the Internal Revenue Service audited .84% of all individual tax returns (Form 1040) and 1.34% of all corporate returns filed. The number of individual income tax returns audited by the IRS has been increasing since 2000 – but mostly for IRS correspondence audits. Taxpayers should be cautious in relying upon overall low statistics. Individual returns (Form 1040) with total proprietorship business receipts of $100,000/$200,000 had a 2.61% audit rate. All individual returns reflecting more than $1,000,000 in income had a 6.21% audit rate.
Taxpayers who file Schedule C (proprietorship business return) are much more likely to be audited than a taxpayer employee who has W-2 income and high itemized deductions.
The IRS relies heavily on its computer systems to select tax returns for audit. Each return received by an IRS Service Center is statistically scored to determine its audit potential. This system is known as the Discriminate Function System (DIF). The DIF score is utilized to determine which returns will be audited. DIF is an unpublished formula. However, we offer the following comments which could be useful:
- Returns with over $1,000,000 in positive income have a 6.21% audit rate.
- Schedule C taxpayers with more than $100,000 of income are very likely audit targets.
- High itemized deductions (Schedule A) tend to be audited if Schedule A deductions are more than 39% of adjusted gross income.
- Sub-chapter S returns (Form 1120S), partnerships and multi-member LLCs have a low audit rate of 0.5%.
- Income tax returns from certain trades, such as commercial and residential contractors and owner operators, tend to be audit targets.
- Cash intensive businesses such as salvage yards and bars have a higher audit rate percentage. Occasionally an IRS special project results in blanket industry taxpayer audits. We have also seen taxpayers audits initiated as part of a blanket audit of returns prepared by suspect tax return preparers.
- Listed are employer/institutional IRS reporting requirements. Mismatch of these forms (called “Wage and Payor” information) with tax returns result in many audits. Additionally, certain tax return characteristics and third party information received by the IRS can result in an audit (see below).
- Form 1099-Misc – Miscellaneous taxpayer income.
- Form 1099-R – withdrawal of retirement income – IRA’s 401(k)’s, state and business retirement plans.
- Form 1099-K – Business taxpayer gross credit card receipts (relatively new compliance check).
- Schedules K-1 from partnerships, limited liability companies, estates and trusts.
- Gambling winnings (Form W-2G) and losses.
- Hobby losses.
- Substantial business vehicle and travel expenses.
- Required bank “suspicious activity” reports filed with the Department of the Treasury – these reports are part of FinCen legislative requirements; large cash transactions and large wire transfers (particularly international); also non routine business checking account deposits or withdrawals; with no notice to bank customers/taxpayers.
- Checking the box on Schedule B indicating a foreign bank account; this indicates a FBAR filing requirement and perhaps a Form 8938 required attachment to Form 1040 filings.
- FACTA legislation, U.S. civil and criminal litigation of foreign account matters; foreign treaties; all of the above have ramped up U.S. resident information available to the IRS concerning foreign accounts and possible unreported foreign income.
- Lifestyle audits are becoming more common. The appearance of availability of more personal funds (e.g., mortgage interest and implied principal payments) than justified by positive income on a filed tax return.
- Leads obtained from whistle blowers, angry family members; former business partners, ancillary information developed during an audit of another taxpayer
The IRS utilizes several different techniques to initiate an audit. At IRS Service Centers, computers are utilized to verify tax computations as well as notify taxpayers of a correspondence audit caused by a mismatch of a filed return to “Wage and Payor” information received. In addition to Service Center letters, audits are often assigned to junior IRS account representatives who conduct audits at local IRS offices. Examinations are also conducted by field Revenue Agents on more complex returns. Revenue Agents are college degreed tax accountants. Audited taxpayers can count on Revenue Agents to closely examine business bank and credit card accounts as well as major business expense categories.
Generally, hiring an experienced tax professional should be considered by taxpayers being audited by a Revenue Agent. Taxpayer interviews before an IRS Revenue Agent are not recommended. There is no requirement that an audited taxpayer must appear before a local IRS account representative or at Revenue Agent conferences.