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.
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 expense or large automobile expense” 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.
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.
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.”
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.
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 verification system. However, self-employed taxpayers are still required to report 100 percent 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.