Tax Talk 2016 FAQ

Avoiding an IRS Audit

I’m an honest taxpayer, but I’ve heard that the IRS is increasing the number of audits the agency will perform this year. What is the IRS looking for?

Most returns are selected for audits by an IRS computer-generated program that compares the deductions you are claiming on your return to other returns in your income bracket.  And many “audits” are now conducted by correspondence with the IRS.

From IRS website: “Some returns are selected for examination on the basis of computer scoring.  Computer programs give each return numeric “scores”. The Discriminant Function System (DIF) score rates the potential for change, based on past IRS experience with similar returns. The Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income. IRS personnel screen the highest-scoring returns, selecting some for audit and identifying the items on these returns that are most likely to need review.

The IRS selects returns using a variety of methods, including: 1) Potential participants in abusive tax avoidance transactions, 2) Computer Scoring-DIF and/or UIDIF, 3) Large Corporations, 4) Information Matching, 5) Related Examinations — Returns may be selected for audit when they involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for examination, or 6) Other — Area offices may identify returns for examination in connection with local compliance projects. These projects require higher level management approval and deal with areas such as local compliance initiatives, return preparers or specific market segments.”

To arrive at a discriminate function (DIF) score, the formula also considers where you live, the size of your family, and how your income is earned. For example, if you were to report income of $60,000, live in an exclusive neighborhood with your family of six, and claim $15,000 in mortgage interest, the IRS may want to chat with you.

How you generate your income may increase the likelihood of your return being selected for an audit. For example, your chances rise sharply if you file Schedule C. That’s because the IRS is well aware that self-employed workers have more opportunities to hide income and to transform personal expenses into business deductions. Workers who receive much of their income in cash, such as those in the gaming, food service, and entertainment industries, also can expect a higher level of scrutiny.

In recent years, the IRS has enhanced its document-matching program, which compares the information sent to the IRS by taxpayers’ employers, clients, and financial services providers to what’s reported on the return. To avoid attracting the attention of IRS auditors, make sure the numbers you report accurately match the information the IRS receives. Check your W-2 wage statements and Form 1099s as soon as you receive them and, if the information is incorrect, ask the issuer to send revised forms to both you and the IRS.

Be sure you record the correct Social Security numbers for yourself, your spouse, and your dependents. The government uses Social Security numbers to check whether a child is claimed as a dependent by more than one person. It’s also important that you review the Social Security numbers on your W-2 forms. According to the IRS, an incorrect number on a Form W-2 results in the return being categorized as “not processible.” In such cases, a refund is delayed until the IRS obtains the correct Social Security number.

Verifying the accuracy of the math on your return is one of the easiest ways to escape a second look by the IRS.

Be careful about claiming deductions for donations not in line with your income. If you report income of $50,000 and donate $10,000, you may be doing a noble thing, but the IRS is likely to want to know more. In such a case, you may want to include support documentation with your tax return.

Although the rules governing who can qualify for the home office deduction were relaxed in over a decade ago, they are still complex and apply to only a limited number of individuals.  While you certainly should claim the home-based office deduction if you operate your business from your home and meet all the requirements, be aware that this might invite IRS scrutiny. Read carefully IRS Publication 587, Business Use of Your Home, before deducting expenses associated with a home office.

What makes you at risk for an audit?

The IRS indicates that budget constraints mean they will perform 100,000 or so fewer audits per year.

The 1-in-104 chance of having an IRS audit vastly overstates the severity of the situation. Fully 70% of all audits are handled by correspondence. However, if your return doesn't include income from a business, rental real estate or a farm, or employee business expense write-offs, the basic 1-in-104 chance of being challenged dwindles to about 1-in-250.

With few exceptions, the IRS is not randomly choosing returns to audit, although random reviews are used to help the IRS calibrate the computers that help them develop their DIF and UIDIF scores.

Simply making more money increases your audit risk.  The IRS will audit about 1.03% of the individual tax returns filed.  However if you make more than $200,000, your risk increases to 3.7%.  And if you make more than $1 million, your chance of having an audit is about 12.5%.

Those claiming the Earned Income Credit are getting extra scrutiny because the IRS has determined that some people are incorrectly claiming the credit or manipulating their returns to qualify or increase the credit.

Additional potential red flags:

  • Failure to report all of your income. 
  • Claiming an office in your home will increase your audit risk.
  • Extensive losses from rental property.
  • Large deductions for business meals, travel and entertainment.
  • Claiming 100% business use of a vehicle.
  • Claiming Day-Trading Losses on Schedule C
  • Failing to Report a Foreign Bank Account
  • Taking Higher-than-Average Deductions
  • Any business or occupation that is known to have a large amount of cash transactions. 

Schedule C losses that look like a hobby loss to an IRS agent.  Especially when the taxpayer has another job and the Schedule appears to be part time with little or no income.

 American Institute of Certified Public Accountants Texas State Board of Public Accountancy