A common taxpayer question is how the IRS decides which tax returns to audit. The IRS uses several methods to identify returns for audit, but regardless of the process used, there are two important points to keep in mind to reduce your risks. The first one is to avoid careless mistakes on your return and the second one is to ensure you have appropriate documentation of all figures you report on tax returns.
Step 1: Identifying returns for review
Tax returns are often selected for audit through information document matching from forms such as W-2s and 1099s and comparing them to filed tax returns. In other words, the IRS will compare the numbers reported by the taxpayer to what was received from employers, banks, and other sources. This is why accuracy is crucial since a mismatch will flag your return.
Another method the IRS uses for evaluating returns involves looking for items outside national averages, such as returns with higher than normal deductions for certain expenses. The IRS uses a type of statistical analysis known as Discriminant Function Scoring to assign scores to returns based on items or amounts that deviate from national norms, as well as other factors that IRS studies have found to be indicators of possible noncompliance.
The IRS also relies on Compliance Initiative Projects, which are conducted on national, regional, and local levels to study perceived areas of noncompliance. The IRS uses the data from these projects to allocate its audit resources in the areas showing significant noncompliance. For example, the IRS identified Schedule C filers with a certain amount of travel, meal, and entertainment deductions as an area of possible noncompliance. Returns that meet these criteria may be flagged for review.
Additionally, the IRS may select returns for audit based on related examinations or informant claims.
Step 2: Examination before contacting the taxpayer
Once returns have been identified, a significant amount of groundwork is conducted before the auditor contacts a taxpayer. For example, auditors typically conduct internet research on the taxpayer, review reports from asset locator services, and compare information from third-party reporters to that reported on the return. The examiner will prepare a cash analysis to determine if the taxpayer has sufficient income to meet his or her expenses and review returns to identify large or unusual items. A three-year comparative analysis of the taxpayer’s returns will also be prepared.
Importantly, the examiner will consider the taxpayer’s current financial situation and collectability in determining the audit’s scope. Based on this analysis, the examiner may choose to “survey” the return as not warranting further examination. The examiner may also choose to survey a return if an examination is deemed unlikely to result in a material change. Extraordinary circumstances, such as death, terminal illness, or bankruptcy, may also warrant survey of the return.
At this stage, the final determination regarding whether to conduct an audit is made by a manager prior to the taxpayer being contacted.
Step 3: Types of audits
There are three main types of audits: correspondence examinations, service center (or office) examinations, and field examinations, each with its own procedures and forms for notification. Taxpayers should note that the IRS will not call taxpayers demanding payment. Notices are sent by mail and contain strict deadlines for responding. As a result, it is crucial that taxpayers take action promptly and appropriately.
If you have received a notice from the IRS, an experienced tax professional can advise you regarding your options and help ensure you do not limit your future rights.