By now, many taxpayers have filed their federal tax returns and hopefully have received refunds or at least broke even. Other taxpayers, who requested extensions to file, continue to gather the necessary information to prepare their returns with the Oct. 16th deadline looming.
No matter which category of taxpayers we belong to, however, most of us as part of the process of preparing and filing our returns, always ask one question: What are the chances that I will be audited?
Although there is no straightforward answer to that question, the Internal Revenue Service gives taxpayers some guidance on how they select returns for audit and publish statistics on how many returns the IRS audits each year. The IRS selects most returns for examination by computerized mathematical techniques and by personnel who identify them for examination.
The DIF difference
Many returns are classified under what is referred to as the DIF system, which stands for discriminate index function and is a computer-based mathematical technique the IRS uses to score income tax returns according to their tax-change potential.
Under the DIF system, the IRS developed mathematical formulas based upon data collected during prior examinations from which computer programs were created.
These programs measure the likelihood of changes to the return based upon the information taken from the return and give the return a DIF score.
The returns are ranked according to score from highest to lowest, with the highest scored returns having the greatest audit potential and made available to examination for manual screening.
The IRS does not, however, publicize what factors the DIF system takes into consideration when scoring the returns.
Experienced examiners also manually classify returns as having audit potential. Examiners look for significant issues likely to result in tax changes that will benefit the IRS. The key requirement for selection is whether the item or issue to be examined is significant.
To decide whether the item or issue is significant, an IRS examiner compares the size of the item against the entire return. That is, the examiner may categorize a $3,000 questionable expense item in a return reporting total expenses of $20,000 as significant, but would likely categorize that same expense item in a return reporting total expenses of $200,000 as not being significant.
Other factors the IRS will consider in determining whether a return should be audited include, but are not limited to:
- Evidence of intent to mislead or conceal.
- The way an item is reported, especially if it benefits the taxpayer.
- The relationship of a questionable item to the other items on the return.
Tax returns are also checked for:
- Correction of mathematical and clerical errors.
- Items not allowed.
- Matching of income and deductions claimed on the tax return against the information reported to it by third parties.
Audits are rare
Although the IRS uses several of the above techniques to identify returns for audit, the number of returns - or lack of returns - actually audited may surprise you. Recently, the IRS issued its annual data book, which summarizes the IRS' audit activity for fiscal year 2005.
This summary includes, among other things, how many returns the IRS audited and what categories of returns it scrutinized the most. According to the IRS data, audit rates are up by 21 percent from the previous year.
For example, of the 130.6 million individual returns filed in 2004, the IRS audited a total of 1.2 million individual returns.
Thus, the amount of individual returns audited in 2005 represents 0.93 percent of all individual returns that were filed compared to .77 percent of all individual returns audited in 2004.
In addition, the audit rate of all corporate returns, other than S corporation returns, increased to 1.24 percent from .71 percent for 2004. The audit rate of S corporation returns increased to .30 percent from .19 percent for 2004.
And, the audit rate for partnership returns increased to .33 percent from .26 percent for 2004.
So, will the IRS choose your return for audit this year? Well, the raw numbers above indicate that it is unlikely.
But keep in mind that the above numbers do not take into consideration items that the IRS has identified that may increase the tax-change potential of a return through one of the IRS' computerized programs, manual examinations, or other audit identification techniques. If a taxpayer has such an item, her chances for audit will significantly increase.
So rather than worrying about being audited and trying to guess what items the IRS maybe looking for, taxpayers should simply follow the law and retain the necessary documentation to support their positions.
