The IRS uses a computer generated program that compares your return to others
in your income bracket and compares the differences in deductions you are taking against
the average in your group. This highly secretive program which produces the DIF
(discriminate function) score is used to select returns that will generate the highest
probability of additional audit revenue.
The program takes into consideration your income, the size of your
family, where you live and how your money is earned. Your DIF score is driven up by
deviations from the norm. For example, if your total income is only $45,000 and you
live in an exclusive residential area with four children, your return would have a higher
probability of being audited. Furthermore, under the same circumstances, if you
claimed $10,000 in charitable deductions, your DIF score would rise. Quite simply,
the IRS program is looking for the likelihood that you are under-reporting income or
What should you do if you know your circumstances will throw your
return into the "deviant" group? Nothing, so long as the income and
deductions are legitimate and can be proven. Simply be aware that you may have to
sit through an IRS audit and provide proof of your expenses and receipts. If you
know that your return has what we refer to as "red flags," you need to be
extraordinarily careful to keep accurate records and receipts.
We often advise clients to take a "proactive" approach
with the IRS if you know you have a red flag deduction on your return. For example,
if you have an unusually large charitable contribution in one particular year, you may
want to attach a copy of the receipt and possibly an explanation as well. That will
not prevent your return from being tagged by the DIF score, but before you are called in
for an audit, a "human" examiner with the IRS will review your return and use
his or her own judgment as to whether your return warrants a desk or field audit (a field
audit occurs when the IRS actually visits your place of business and requests records on
The risk of being audited is not spread evenly across the population
as you have probably guessed. The IRS uses the same cost-benefit ratio used by
businesses when considering a potential audit. Put quite simply, if you are in a low
income bracket, it may not be worth the agent's time to bring you in for an audit that
will yield only a few dollars in disallowed deductions.
Historically, the IRS has used random sampling to pull returns for
audit regardless of anything on the return. That practice, however, has come under
increasing attack by Congress. The DIF score audits will likely remain alive and well
Obviously, if having a low income decreases your chance of being
audited, being a high-income taxpayer will definitely increase your risk. Being
self-employed will increase it even further. The IRS is aware (as we are) that the
potential tax deductions available to self-employed individuals is tremendously greater
than those available to wage-earners. Statistics show that deductions for travel,
auto and entertainment are at the top of the IRS' target list. Why? Because
all too many people either fail to keep the required documentation or they take deductions
that have dubious business purposes (such as taking a spouse to a conference in Hawaii).
Professions that deal heavily in cash transactions have also faced a
greater degree of audit risk. Employees in the food service and entertainment
industries are typically audited for under-reporting of tips and other cash income.
What To Do In The Event Of An Audit
What should you do if you're called in for an audit? First of
all, find your records and get them in order. The more organized and professional
you appear to be, the more likely it is that your records will be taken seriously.
Secondly, if we prepared your return, call us. We can sit down with you and review
your return and your records in order to determine where your potential risks may
It may actually better to have us represent you before the IRS. We are
far more likely to know where the agent is going with his or her questions and, more
importantly, we will have a better understanding of when to not volunteer more information
than is necessary. All too often, clients will begin speaking and volunteer much
more information to the agent than was necessary to respond to the inquiries.
Overall, your risk of being audited is less than 2 percent. Of
course, if your return has one of the red flags we mentioned above, that risk increases
dramatically. Legally, under the statute of limitations, the IRS has three years to
pull your return for an audit (unless they can prove fraud). In real practice,
however, since the audit process takes time, most returns are audited within one to two
years after filing.
If you are suffering sleepless nights worrying about a potential
audit on a return you have filed, please give us a call. We should be able to either
put your mind at ease, or at the very least, let you know exactly what your liability
might be in the event of an audit. If your return was filed incorrectly and the
likelihood of an audit is high, it may be better to file an amended return now and avoid
the high penalties that could be involved with an audit.