Travis H. Long, CPA, Inc. Blog

Originally published in the Cedar Street Times

May 30, 2014

Two weeks ago I discussed some of the statistics regarding your chances of being audited by the IRS.  A few of the high points from that article were: 1) on the average, audit rates for individuals are generally less than one percent each year, although audit rates jump to over three percent on people making over $200,000 a year, 2) about 75 percent of audits are actually mail correspondence audits focused on a narrow request of information for specific items on your return rather than a full-blown in-person, field audit, 3) partnership, LLC, and s-corporations have a less than half of one percent chance of being audited, while small c-corporations with less than $10 million in assets have an audit rate just under one percent, 4) larger c-corporations have increasingly higher chances of being audited with a roughly one in three chance for corporations with over $250 million in assets.  If you would like to read the full article, you can read it on my website at http://www.tlongcpa.com/blog.  The rest of this article will be devoted to audit selection and in two weeks we will discuss “red flags.”

Regarding audit selection, let me start by saying that no matter what you read or hear, nobody knows the exact methodology the IRS uses to select returns for audit as it is not public information.  All we really know is the broad overview the IRS tells us about its methodology and the limited statistical information the IRS releases about audits; the rest is conjecture based on the type of returns that we as tax practitioners see being audited.  Of course that can be warped by our own experiences.  That said, when you have been in the field long enough and have read about or talked to others about their experiences, you do get a good idea of the common issues for the types of clients with which you work.  When a client comes in and says, “I heard that if you report over ‘x amount’ of this, it is a red flag,” or “I am not going to file until ‘this date’ because you are less likely to be audited,” I know they have latched onto some misguided information.

So what does the IRS say about their audit selection tools and methods?  First, they tell us there is a computer scoring system called “Discriminant Inventory Function System” (DIF).  This system looks at your return and compares your return to similar returns to come up with a score for your return; the higher your score, the more likely an audit will yield a tax change.

Secondly, they use computers to match information reported on your return with information reported by third parties such as on Forms W-2, 1099, 1098, and the like.  Automatic notices can be generated as a result of mismatched items.

Third, they admit to using a variety of other tactics and resources such as the internet, newspapers, and other public information, or even people who may file a complaint or “squeal” on you.  They say they will investigate these sources for reliability before using it for an examination.

They also have the right to contact third parties about you, such as neighbors, co-workers, bankers, etc. Generally they have to inform you if they contact someone else unless they feel it would jeopardize their ability to collect the tax or that you might retaliate against the individual.

Although I have not seen this written as a tactic employed, I am aware of a situation where the IRS was selecting returns because they were prepared by a particular tax professional in a particular industry (and no, it wasn’t me!).

In addition there have been various programs over the years such as the Taxpayer Compliance Measurement Program and the more current National Research Program which introduces a random statistical selection methodology.  One of the uses for the information gathered in this program is to fine-tune the DIF computer scoring system.  It also means that ANYONE can be audited.

In two weeks we will discuss “red flags.”

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.