The following sketch is the picture of a successful business owner, but she’s afraid of finding herself in the crosshairs of the IRS very soon (the name has been fictionalized).
Alice is in her early 50s, recently engaged and owns two businesses – an S corp that's in the midst of rapid growth with a $1.3M gross and a $360K net income for 2020. She's a 100 percent shareholder and expects to double this business in 2021.
Alice also wants to plan for a potential secondary corporate entity for bringing on equity partners related to this business, while keeping a separate IP.
Here’s where things get a little sticky. Alice also has another business, a c-corp entity, a startup founded in 2017, that has a $86K net loss for 2018 for which she’s neglected to file a tax return and $31K net loss for 2020.
As a 90% shareholder, she has decided to dissolve the corp by the end of December 2020, and get married for tax reasons. Knowing that the IRS might be interested in the neglected tax return at this time, Alice emailed me for a consultation.
Auditing People Since 1862
If you get audited by the IRS, you are probably wondering why. It is a valid concern shared by many small business owners but unfortunately, like with Alice’s situation, there is not any easy answer. The IRS audits people for many different reasons, but generally speaking, when the IRS audits an individual or a business, it is expecting to yield additional tax due on a return.
The IRS has been processing tax returns and auditing people for a very, very long time – since 1862 in fact. It is quite good at auditing people but because the government has limited resources, it really focuses on the areas where it thinks it can get the biggest win. The biggest win translates to how much additional tax revenue the IRS can raise through examination.
At Brotman Law, we have defended all kinds of small business audits and know how to help our clients prepare so they can get through the process with as little disruption and few pain points as possible. We specialize in addressing the tax issues faced by small businesses and are qualified to practice before the IRS.
In this segment, I will talk about the IRS process for selecting which taxpayers to audit, including data tests and how concerned you should be if you are selected.
It’s Not Just You
The IRS has limited resources. Because of this, it must maximize those resources to yield as much back to the government as possible and to keep taxpayers in compliance. People get audited for a variety of different reasons, and as I like to say, everybody's tax return tells a story. A tax return is a wealth of information and gives the IRS important data about your income, your deductions and the way that you live your life.
When that story does not match up to the numbers on your return, if the IRS wants to know why, it will audit the return. For example, a number of the things that we consider traditional audit red flags — such as round numbers or increased travel expenses or meals and entertainment deductions — are more likely than not to get picked up by the IRS in an audit.
The IRS has developed a statistical body of data points and the relationship that your return has to those data points, dictates how likely you are to get audited.
A taxpayer will file a tax return and that tax return will get scored by two methods. One is called the DIF score and the other is called the UI DIF score. DIF stands for discriminant income function. What the IRS is looking for when it scores returns based on a DIF score is the propensity for error in the taxpayers return.
For example, if a taxpayer’s claimed expenses are not in line with either their profession or with the level of income that is on the return, or inconsistent with a couple of other factors, then that return will generally receive a high DIF score and be subject to audit. A high DIF score translates to the IRS believing that the return has a higher propensity for error.
UI DIF Score
Ever wonder how tax returns are selected for audit? Well, it comes down to two simple numbers which are your DIF Score and your UI DIF Score
The UI DIF Score is when the IRS is looking at the propensity that the return has a high level of unreported income. The IRS uses those two scores (DIF and UI DIF) to select people based on where they fall within a data pool and then they go from there to determine who gets audited.
This moves on to a manual review and there is a human being who looks through this data and makes decisions. The IRS uses statistics as much as possible to get a pool of returns that feels appropriate for audit, and then selects the "low hanging fruit" — or the ones that they think they can get the most money out of.
According to the IRS, tax returns are selected for audit based on computer scoring. The IRS states in Publication 556 that it uses a computer program called the Discriminant Inventory Function System (DIF). The Discriminant Inventory Function System assigns a numeric score to each individual and some corporate tax returns after they have been processed.
If your return is selected because of a high score under the DIF system, the potential is high that an examination of your return will result in a change to your income tax liability.
Purpose of Discriminant Inventory Function (DIF)
Essentially, the two-fold purpose of the DIF is to identify and select tax returns for examination utilizing a pre-configured scoring formula. Each type of taxpayer and tax return is subject to a different DIF formula. There are particular items on a tax return that may cause concern.
For example, participation in a tax shelter might send up a red flag to the Internal Revenue Service. In addition, “large charitable contributions, home office deductions, large travel and entertainment expenses or large automobile expenses” may send up additional red flags (MBBP).
Once a tax return is selected under the DIF program, it is then manually screened so attachments and related data can be evaluated.
Purpose of Unreported Income DIF
The IRS uses an additional tool, namely the Unreported Income Discriminant Index Formula (UI DIF). The UI DIF is used for two purposes:
- To rate the probability of inaccurate information
- To rate the probability of omitted income on a tax return
Both steps are evaluated in conjunction with the other.
For example, if a taxpayer files a 1040-EZ tax return, reporting earnings from a W-2 only, then it is unlikely that the tax filing will be subject to an audit; this is because the earnings reported on the tax return also match those earnings reported with Social Security.
However, a tax filer that reports income from various sources and fails to provide hard-copy documentation evidencing self-employment earnings, for example, will likely have a better chance of responding to an audit request.
With this in mind, with regard to the UI DIF, the IRS typically targets four areas when considering an audit.
The High Income, High Risk Taxpayer
The first area is “high income, high risk taxpayers.”
A taxpayer with a higher income tends to file a more complicated tax return. Under this category, the taxpayer engages in pass-through activities that include tax shelters, the establishment of trusts, and related taxation shielding options.
Because some activities may be illegal, tax returns that fall under this category are likely to be audited.
The High Income Non-Filer Taxpayer
The second category is “high income non-filers.”
A taxpayer with high income reported on their social security number, but who has not filed a tax return yet, is screened by the IRS. The IRS will send multiple notices, advising the high income taxpayer of their legal obligation to file and will also prepare a Substitute for Return (SFR).
For more information on Substitute for Return, see section “Other Types of Balances Due: Proposed Assessments and Substitute for Returns.”
The High Amounts of Itemized Deductions Taxpayer
The third area the IRS evaluates is the “high amounts of itemized deductions” reported by the taxpayer.
A taxpayer can itemize their own tax deductions using Schedule A (Form 1040); using the form is an alternative to taking the standard deductions based upon individual filing status. Although the taxpayer can elect to itemize their deductions, too many discretionary deductions and calculations may result in error and fraud.
The Self-Employed Taxpayers
Self-employed taxpayers are also vulnerable to an audit. Self-employed taxpayers are different from earning individuals because the income derived as a result of self-employment is not subject to a standard W-2 verification system.
In addition, several deductions such as business expense write-offs and home office deductions which are not available to other employees reduces their income subject to federal and state income taxes.
However, self-employed taxpayers are still required to report 100% of their earnings and are free to deduct all legal expenses. Too many deductions without documentation will eventually subject the self-employed taxpayer to an audit.
There Is a Way Forward
If you’ve read this far, and I hope you have, you should now have a good understanding of the unique system of scoring used by the IRS, the four areas it examines when considering an audit and why they would center their crosshairs on your tax return.
If you’ve neglected to file a tax return for some years, or there is some activity behind your income that might be a little on the shady side, call me for a consultation and we’ll take a look at your situation. I’ve worked with many individuals and business owners from all walks of life that had some severe tax penalties racked up. In most cases I negotiated their bills down quite a bit.
If you are afraid you’re going to get audited by the IRS, are currently in the process of being audited or, were audited and you disagree with the penalties levied on you, give me a call today. It will lessen any panic you have.