Full disclosure here, the IRS does not reveal the exact criteria that it uses to audit a tax return. However, this closely guarded statistic is not so much of a secret anymore. Not surprisingly, the government uses statistics to analyze tax returns and to determine which taxpayers it selects for IRS audits. Shameless self-promotion alert: I have also written a pretty comprehensive list of the factors that the IRS that are known by tax attorneys as “audit red flags.” However, in this post, I want to discuss perhaps the most important factor in avoiding an IRS audit: essentially making it bulletproof from the scrutiny of the IRS.
Here’s a quick recap about how IRS audits work. All tax returns are processed into a computer, where they are assigned two scores: a DIF score (assessing the potential changes on a tax return [i.e. increased revenue]) and a UDIF score (assessing the potential that there is unreported income on a tax return). Returns with high scores are sent to an IRS reviewer, who manually examines a return to determine its potential for audit. Those that are selected by the reviewer are sent to local field offices where a revenue agent will conduct an IRS audit. Those not selected by the reviewer are tossed back into the pile (so to speak) and are safe from audit.
The fact of the matter is that the IRS can only conduct a certain amount of IRS audits per year, so it selects the tax returns that are most likely to yield revenue or that contain the greatest potential for error for additional review. Think of it from the government’s perspective: why would they devote manpower, time, and limited resources toward auditing a return that is likely not going to yield them additional revenue? Answer: they probably won’t.
So, how does this all relate to you, your tax return and avoiding an IRS audit? Simple. When preparing your return this year, ask yourself this question: DOES MY TAX RETURN MAKE SENSE? Is all my income accounted for and reported correctly? Do the deductions listed on my Schedule A (where you itemize) make sense? Do I have excessive charitable contributions for someone of my income level (especially in comparison to the past three years)? Do my business expenses make sense (are you a plumber that wrote off international travel) and are they likely to be considered ordinary and necessary by the IRS?
Do you see where I am going with this? Most of the tax returns that come across my desk as a tax attorney that have been selected by the IRS for audit have some burning question that I cannot answer off the bat. They are like the video ads in Starship Troopers that keep asking, “Would you like to know more?” (Yes, I was able to make a Starship Troopers reference in a tax article). If your return comes across my desk and I am left asking questions, then that’s probably the reason your return was selected for an IRS audit (i.e. the manual reviewer had those same questions).
So spend the extra time to make sure that everything on your return makes sense and, if it doesn’t, then the IRS allows you to attach a supplemental statement to return that explains certain items. Little used by tax professionals and individuals preparing their returns, these statements can actually help you avoid an audit by giving you a chance to explain out items that may be problematic on the return. More than that though is that a well-written articulate statement written about an item on a tax return sends a message to the reviewer that the person on the other end of this return has the ducks in a row. And if that person is prepared to defend their return, then there is a good chance that auditing that return will lead to no change, and if it leads to no change (hint: the IRS likely does not want to audit it).
So here is the takeaway: if your return makes sense and everything is well explained, then you will likely never encounter the pain of going through an IRS audit (hiring people like me, digging out old records, devoting significant time and expense). My advice here is to take the extra time going over everything to make sure everything on your return is in order. Hire a competent CPA or tax attorney, like this guy, to prepare your return. Go through the motions now and save yourself a lot of trouble later.