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IRS AUDIT MATTERS - THE AUDIT LOTTERY

A taxpayer must be very unlucky to be selected for audit. In a recent government fiscal year, the Internal Revenue Service only audited .80% of all individual income tax returns and 2.59% of all corporate returns filed. The number of returns audited by the IRS has substantially decreased since 1985.

The greater a taxpayer's reported income, the greater the chance that an individual's return will be audited. For example, individuals earning in excess of $100,000.00 are nines times as likely to be audited as those individuals earning less than $25,000.00.

Taxpayers who file a Schedule C are much more likely to be audited than a taxpayer employee who has W-2 income and high itemized deductions. With regard to corporations, high income and high asset corporations are much more likely to be audited than small corporations. For example, the IRS audits approximately 75% of all corporate tax returns which have gross assets in excess of $250,000,000.00. It audits approximately 1% of those corporate returns reporting under $50,000.00 in assets.

The IRS relies heavily on its computer system to select tax returns for audit. Each return received by an IRS Service Center is statistically scored to determine its audit potential. The system is known as the Discriminate Function System (DIF).

IRS computers analyze two primary measures in determining an initial DIF score: total positive income and total gross receipts. Total positive income is the sum of all income items on a return. With regard to returns reporting business receipts, Schedule C and Schedule F, gross income is the primary focus.

The IRS believes that business gross receipts are better indicators of audit dollars than net business income reported on the return (Internal Revenue Manual MT 40(10)0-1-140). For non-business tax returns, other items on an individual's return will act as red flags causing the IRS to consider sending the taxpayer a written inquiry or worse, conducting an examination of that taxpayer's return. Some of the red flags are as follows:

• If the Service Center must write the taxpayer concerning missing schedules and that taxpayer fails to respond, that return will generate higher DIF scores.
• Omission of Form 8283 (Non-Cash Charitable Contribution) will raise the DIF score.
• Failure to file an Alternative Minimum Tax Schedule (Form 6251) on a Form 1040 will increase chances of audit.
• Casualty losses will increase chances that a taxpayer will be audited.
• The greater the assets on a reported balance sheet, the greater the chance that return might be audited.
• An affirmative answer with respect to foreign bank accounts increases the chance of audit.
• Returns which claim tax credits will receive a higher DIF score.
• High itemized deductions (e.g., mortgage payments and real estate taxes) relative to total positive income reported on a return will create a higher DIF score.
• Multi-year Schedule C losses, without intervening years of net income, will increase DIF scores.
• Form 1099 income reported to the IRS but not appearing anywhere on a taxpayer's income tax return will, at a minimum, invite correspondence from the Internal Revenue Service.
• A lack of federal income tax withholding on a taxpayer's Form W-2 (Employee Statement of Earnings) may flag a taxpayer as non compliant and perhaps a tax protester.
• Schedules C and F increase the likelihood of a higher DIF score.
• Schedule C gross sales in relation to gross profit and net profit for a particular business code will raise DIF scores.
• High itemized deductions in comparison to other residents of the same geographical area, will raise DIF scores.

The IRS utilizes several different examination techniques to determine the accuracy of tax returns. At an IRS Service Center, computers are utilized to verify the computations shown on each return. The Service Center also conducts correspondence audits by initiating letters to taxpayers requiring verification of deductions and/or exemptions shown on a return. Office audits, conducted by non-accountant IRS representatives, are conducted in local offices. Field examinations are conducted by Revenue Agents on more complex Form 1040 returns. Revenue Agents are college degreed accountants.