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IRS Audit Red Flags – Part One – Why IRS Audits Occur

Every year, the IRS sends out thousands of notices to taxpayers informing them that they have been selected for an IRS audit. Audits are scary situations for many taxpayers. They involve the government prying into your personal financial affairs and requesting sometimes very sensitive financial information from you. They sometimes provoke feelings of fear and that the taxpayer has done something wrong in eyes of the government. In addition, audits are time-consuming and can be potentially very costly when you factor in any penalties assessed or any interest on the assessed liability. Even though most honest people who keep good records have nothing to fear, no one likes to be audited. I am often asked as an attorney for things that my clients are able to do to reduce their risk of audit. In order to better serve them, I have put together this multi-part article on audits and tax return red flags.

About audits

First, I want to explain a little about the process and how audits work. The Examinations Division is the group within the IRS that handles auditing your tax return. The government takes audits seriously, as not only does it help them catch tax cheats, but is also a major source of revenue for the government. According to internal IRS statistics, The IRS collected almost $17.5 billion dollars from its Examination Division in 2009. Audit rates have increased nearly 100% from the year 2000. So, it is fairly easy to conclude that not only are audits not going anywhere, but also the number of people being audited is steadily increasing.

The IRS audits people for a variety of reasons, but mainly it is to find potential tax revenue that was not reported on tax return. This comes in two forms: understated income and overstated deductions. Now the IRS simply does not have the resources to audit everyone’s return. Therefore, it prioritizes based on certain factors about the information reported in the return and the person who filed it. The IRS keeps these factors (and their priority level) are kept under strict secrecy. However, there are several pieces of information that we know and other information that we can infer from the history of returns that have been audited.

When returns are filed, whether by hand or electronically, they are entered into a computer system and processed. The information in the return is then assigned a numeric score under two scoring systems.[1] These scoring systems are known as the Discriminant Function System (DIF) score and the Unreported Income Discriminant Function System (UIDIF) score. DIF scores regard the potential that information in the return would change if it were audited and UIDIF scores regard the potential that the return contains under-reported income. Once returns are scored, the highest scoring returns are separated and reviewed manually by an examination technician who determines which returns should be selected for audit and which line items in particular are in need of extra review. That person also determines the level of audit needed for the particular return in question (simple issues are resolved via the mail, the most complex require a field visit by an IRS auditor).

So the goal is obviously to reduce your DIF and UIDIF scores enough so that your return avoids the scrutiny of the computer and does not get selected for manual examination. Continue reading for more explanation on how to go about this.

Continue to IRS Audit Red Flags – Part Two – Common Errors

Article Index

IRS Audit Red Flags – Part One – Why IRS Audits Occur

IRS Audit Red Flags – Part Two – Common Errors

IRS Audit Red Flags – Part Three – Frequent IRS Targets

IRS Audit Red Flags – Part Four – Cash

IRS Audit Red Flags – Part Five – Schedule A and E

IRS Audit Red Flags – Part Six – Employee Audit Red Flags

IRS Audit Red Flags – Part Seven – Schedule C Expenses

IRS Audit Red Flags – Part Eight – Schedule C Losses and Schedule B and D

IRS Audit Red Flags – Part Nine – Margins

IRS Audit Red Flags – Part Ten – The Self Employed/Conclusion

[1] See The Examination (Audit) Process, found here: http://www.irs.gov/uac/The-Examination-(Audit)-Process