“Why me?” is the plaintive cry from most taxpayers facing an examination from the IRS. You can ask the auditor why all day long, but he’ll just shrug and say, “I don’t know. I’m just doing my job.” Once in a while an auditor may give you her best guess as to why you were selected, but don’t count on it.
To be fair, there tends to be a good reason a tax return is flagged for an audit. Sometimes it is a random spin-of-the-wheel choice, but in most cases there’s a catalyst to the red flag. So here’s some insight:
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Dif Scores. Electronic filing has made it much easier for the IRS to gather data in order to analyze population groupings, standards and trends. A simple act of feeding in parameters to existing data can provide information regarding queries like: How many home owners exist in a certain nine-digit ZIP code, or what is the average income in Wichita?
The IRS developed a method of computer scoring called the Discriminant Function System (DIF) score which rates the potential for change based on past IRS experience with similar returns. The Unreported Income DIF (UIDIF) score rates tax returns for the potential of unreported income. The highest-scoring returns are reviewed by IRS personnel and from there some are selected for audit with pointers to items on the return that need review.
So: You might be audited if you live in Bel Air, pay DMV tags for a Lamborghini, and pay interest on a million-dollar mortgage yet declare less than $100,000 of income. Although there may be a very good reason for this--maybe you earned millions in 2010 and left the workforce in 2011 to kick back and spend your fortune-- the IRS will suspect you aren’t reporting all of your income, and will want to take a peek.
Abusive tax avoidance transactions. Some folks are audited because they participate in abusive tax avoidance transactions. The IRS identifies promoters and participants usually from tipsters or from lists of participants that promoters have been court-ordered to turn over to the IRS. Be very wary when investing into those “too-good-to-be-true” tax shelters. Always run them by your tax pro.
Related examinations. I defended a general contractor in an audit recently. The IRS noticed that he had neglected to send out Forms 1099 to his subcontractors and then identified the subcontractors and checked their tax returns to see if they had declared the income--several had not. The agency pounced on those who had not – easy prey. I’ve had clients tell me that since they didn’t get a 1099, they didn’t think they were required to report the income. Not so. If you have self-employment income of $400 or more, you are required to file a tax return whether you receive a 1099 or not.
Specific market segments. Every year the IRS selects a particular industry for compliance examinations. In the last couple of years they have concentrated on foreign trusts with the idea of uncovering unreported income from offshore accounts. A few years ago they looked at attorneys incorporated as Sub S corporations attempting to reclassify dividends as wages for those who take low salaries but large distributions thus saving money on employment taxes. One year they went after servers in restaurants to collect on unreported tip income. Every year the agency chooses an industry to scrutinize based on suspected abuse hot spots.
Automatic Underreporter Program (AUR) and Information Matching. Employers, banks, brokerage firms, payers of independent contractors all file documents with the IRS and send the same documents – Forms 1099, W2, 1098, K-1, etc. to taxpayers. If you neglect to report any of the data on these forms, or report an amount different than what is on the form, the IRS picks up on it. Usually, it sends out a letter CP- 2000 relaying the information and billing the taxpayer for additional taxes. Sometimes an agent shows up on your doorstep.
Amended returns are often times flagged for audit, especially if the information you are changing involves increasing deductions in red flag areas such as travel, meals and entertainment and automobile expense.
Don’t be afraid to amend if you have cause. However, if you are amending your income tax return, be sure you can substantiate all deductions and income.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.