One of the most stressful tax related experiences is receiving a notice from the IRS stating that they want to examine your tax return. Now you’ll need to provide reasoning for why your return was prepared the way it was with supporting documentation for the deductions taken and income reported. The biggest question you may ask yourself upon receiving the notice is, “Why me?”
We will discuss in this blog how the IRS selects returns to be audited.
THE DISCRIMINATE FUNCTION SYSTEM
Perhaps you’re already aware that when your tax return is filed it is scanned through a computer program. This program is the Discriminate Function System (DIF) and is designed to find errors on a tax return. It produces a score for your tax return using a mathematical formula that has been compiled of historic data from other examination programs and past audits. If your DIF score is high enough, the tax return has a high probability of being examined.
Part of the DIF score your tax return receives comes from the matching of income you reported on your tax return to the income that was reported to the IRS from your employer(s), banks, or brokers. This part of your score is called the Unreported Income DIF (UIDIF). When the program detects large discrepancies in this area, generally due to income being left off of a return, your chance of being audited is almost certain.
Once the score on your tax return has been calculated and is high enough, a examiner from the IRS will screen your return. Upon screening the return, the examiner will then determine whether the return will need to undergo an audit and select the items on the return that need to be examined.
Other items that could possibly trigger an audit under the DIF are:
- Large charitable contributions
- Home Office Deductions
- Participation in a tax shelter
- Large automobile expenses
- Large travel and entertainment expenses
THE PERSON PREPARING YOUR RETURN
Be very cautious of tax preparers who are promising extremely large refunds or that talk about taking deductions on your return for expenses you never had. Also, be sure to review the return yourself to make sure everything looks correct. When the IRS selects several taxpayers’ returns to be examined and they see the same preparer’s name on all of the returns that is a red flag. The IRS will begin looking at other returns prepared by the same preparer because chances are the preparer was fraudulently filing returns.
Also, the IRS does audit tax preparers. Typically, the IRS is looking for certain due diligence forms the preparer is supposed to store and maintain (EITC, CTC, etc.). When the IRS identifies other deficiencies with the preparer it is possible for subsequent audits to go out to the preparer’s clients. In fact, a few years ago a San Diego tax preparer was sentenced to 7 years in prison after filing thousands of false tax returns. Many of her former clients were audited too.
The DIF is not the only reason why the IRS may select your tax return to be examined. Your tax return may be selected for an audit simply because a person you do business with is being audited. This could be someone that is a business partner of yours or someone that is an investor in your business. A related examination could also come about because someone you had previously done business with, where money or property was exchanged for services or other property, is currently being audited or was previously audited.
If you have previously been audited, the chances of your tax return being audited increase. Though you may be filing everything correctly it is important to be extremely cautious when preparing your tax return if you’ve previously been audited. The IRS will be looking closely at tax returns from taxpayers who were audited within the past few years.
OTHER REASON FOR BEING SELECTED
- Amending your return
- Omitting information on a return (whether intentionally or unintentionally)
- History of non-filing
- You have foreign assets
- You own a large corporation
There are many ways the IRS goes about identifying returns to examine and sometimes it is completely random. Hopefully with the information above you can avoid an IRS audit but, if you are audited don’t panic. You still have options available to you. If you feel as though you are ill-equipped to handle the audit yourself, seek legal representation so you don’t do or say something that could cause a further look into previous years.