How does the IRS decide who to audit?

How does the IRS decide who to audit?
Ines Zemelman, EA
15 January 2018

They say that the best defense is a good offense. So, to understand the best way to react to an audit from the IRS, it helps to understand the methods the IRS uses to select tax returns for audit. There are several methods that are used by the IRS. Some of them are objective and based on confidential formulas in the IRS computer system. Others are subjective and based on investigative work by IRS agents.

Keep in mind that just because you receive notice of an audit, it does not necessarily mean that there is a problem with your return.

Random Computer Selection

The IRS chooses some tax returns to audit by comparing your return to statistical data for similar tax returns. This statistical data is developed from historical audits of random samples of returns under the IRS National Research Program. As new data is gathered, the IRS updates the return selection formula.

Other returns  are chosen by computer based on the Discriminant Function System, or DIF. This mathematical formula is used to analyze each return and score it using data from previous IRS audits. The tax returns that score poorly are examined manually for potential further audit action. This formula is periodically updated to reflect current statistical data.

There are different formulas for different categories of taxpayers. The specific DIF formulas and other program details are not made public, but experience shows that certain things are more likely to generate a high DIF score and cause the tax return to get chosen for manual examination. These items include:

  • Large expenses for automobiles
  • Large expenses for travel and entertainment, such as sky box seats
  • Large deductions for home offices
  • Large contributions to charities
  • Using tax shelters

Once a return is selected for manual examination, an IRS examiner can properly consider attachments, notes made on the tax return, and additional information that the computer formula could not take into account before deciding whether or not to audit the return.

Some returns are chosen randomly rather than by using statistical data. This allows the IRS to feed current data to the statistical methods and to measure taxpayer compliance.

Referral From Other Agencies

The IRS can receive tips or data from other state and federal agencies that lead them to believe an audit is appropriate for a particular return.

Related Audits

If the IRS sees mistakes or fraud on the tax returns of others who have a financial relationship, they may choose to conduct an audit. Examples include a taxpayer’s business partner or investors. This is commonly called “audit by infection”.

IRS Selection

Regardless of the method of selection, once a return is selected an auditor will examine the return. The auditor may either accept the return, or if they see items requiring further investigation they will note those items and send the return on to another department for further investigation.

A couple of things to note:

  • Getting a refund is not, in itself, an audit trigger. But, it may cause a return to be examined further.
  • If you file an amended tax return, that does not have any effect on the process of selecting the original tax return for examination or audit. Amended returns go through the same process and may be selected on their own for further review.

Third Party Information

The IRS uses data provided by third parties during the examination and selection process. This includes forms like the W-2, or 1099, received from places such as brokers, banks, and employers. If this data does not match what is reported on your return, it is likely to trigger further examination.

IRS Agent Referrals

IRS agents can make referrals based on the work they are doing with related returns (e.g., business partners). If the IRS receives tips about potential tax noncompliance, they may also choose to audit those returns.

Errors

Tax return examinations and audits can be triggered by errors on the tax return, including missing information or mathematical errors.

Remember that the Internal Revenue Service’s authority to audit and review tax returns is very broad. But, if you understand your rights as well as the IRS’s responsibilities, you can better manage the examination and audit process, which can result in a more positive outcome.

Ines Zemelman, EA
founder of Taxes for Expats