Winning Your Audit Part 2: Audit Selection

This is part 2 of 6 of our in-depth guide to winning your audit.

Audit Selection—Why Me, O Lord?

You just got an examination notice from the IRS. Are you merely unlucky, or are there more sinister forces at work?

Computers and Classifiers

The IRS computer is to blame for most audits. Each year, your tax return data is sent to the IRS National Computer Center where it is analyzed by a computer program called the Discriminant Function. Your tax return is given a numerical DIF score—the higher the score, the more audit potential the return has.

The DIF program is super-secret—few people even in the IRS know how it works or why a return is given a particular score. Outsiders guess that hundreds of variables on a return are weighed by the IRS computer. One known variable is called “total positive income,” which means everything you took in from your services and investments, before any deductions or exemptions. If this number is over $100,000, your chances of an audit double (roughly). If you earn more than $1 million, your audit rate is nearly 10%. The key variable is believed to be the percentage of deductions and the number of exemptions claimed.

The IRS has a second computer scoring program to catch people not reporting all of their income. This is a slightly different approach from the DIF program, which relies heavily on deductions and exemptions claimed. This program is called the Unreported Income Discriminate Information Function (UIDIF). It scores individuals based on a high-expense/low-income ratio. In plain English, the tax man is looking for folks who look like they are living beyond their means. For instance, you and your spouse report income from your jobs of $40,000 and you claim mortgage interest and real estate taxes of $35,000. Even assuming that you didn’t owe any taxes that year, it would be tough to live on $5,000—so the IRS believes. Of course, some people have down income years and simply borrow or dip into savings to get by. These explanations can always be made to an auditor, if necessary.

One in ten tax returns—those with the highest computer scores—are initially selected for further review. IRS classifiers (human beings) then look at this batch and recommend approximately 10% for audit.

The final say-so on who gets audited face-to-face is made at local IRS offices by examination group managers. These people supervise and assign the auditors, often according to their experience and expertise. Managers decide whether you will be audited at the IRS office or will get a more rigorous field audit.

IRS field offices have their own audit-screening selection process which takes into account income and expense levels in their communities—for instance, people are more likely to claim car expenses for business in Los Angeles than Manhattan. Group managers select less than 10% of the returns received from the IRS classifiers—the 10% of all tax returns—to be audited. Historically, the net result is that only about ¾ of 1% of all returns are actually audited.

The computer is not the only way the IRS picks its audit victims. See, “Other Reasons for Audits,” below for other ways your number might come up.

According to the IRS Manual, only significant items should be examined. What is considered significant depends on the IRS’s overall view of the return as well as particular items that seem questionable. Factors that are likely to figure into the audit selection process include:

• Comparative size of an item to the rest of the return. A $5,000 expense on a tax return reporting $25,000 in income would be significant; the same expense on a $100,000 income return wouldn’t be.
• An item on the return is out of character for the taxpayer. A plumber claiming expenses relating to a business airplane would cause suspicion.
• An item is reported at an inappropriate place on the return. For example, $2,000 of credit card interest reported as a business expense. The IRS might suspect that you improperly deducted personal interest as a business expense.
• Evidence of intent to mislead on the return. Filing a tax return with missing schedules or not providing all information asked for on the forms raises an IRS classifier’s eyebrows.
• Your gross income. The IRS scrutinizes higher earners. If you make over $100,000 per year, your audit likelihood is one in 20 versus one in 100 for the general population.
• Self-employment income. The IRS is most suspicious of people in business for themselves. Sole proprietors are four times more likely to be audited than a wage earner.
• Losses from businesses and investments claimed on the tax return. If your business and investments show losses on your tax return, the IRS may want to know how you paid your bills. Most likely to be audited are taxpayers reporting a small business loss.
• Sloppiness and round numbers. A messy return, especially if handwritten, attracts a classifier’s attention. He may think you don’t take your tax-reporting responsibilities very seriously. Use of round numbers—for example, $5,000 for business advertising, $2,000 for transportation and $1,500 for insurance—is a dead giveaway that you are estimating, not reporting from records.

Are You Claiming More Deductions Than the Norm?

One of the chief components of the IRS DIF scoring system is how close your tax return is to the norm of others with similar deductions. According to author Amir Aczel (How to Beat the IRS at Its Own Game, $14.95, Four Walls Eight Windows Press), the IRS is most likely to audit you if your return shows a high ratio of deductions to income on three schedules:

• Schedule A, Itemized Deductions
• Schedule C, Profit and Loss from Business, or
• Schedule F, Profit and Loss from Farming.

Aczel claims that, as a rule, as your deductions approach 50% of your income, your audit likelihood rises. He lists precise ratios based on a study of 1,200 audit cases. For example, he claims that taxpayers filing a Schedule C are rarely audited if they claim expenses of less than 52% of gross business income, but are often audited when claiming expenses of more than 63%. If you include a Schedule A with your tax return, Aczel claims you are safe from an audit if your deductions are less than 44% of your gross income. While his book is interesting, don’t use it as a manual to avoid a tax audit. I say if you are entitled to a deduction, take it, no matter what the chances of audit are.

Can You Get Audited If You Don’t File a Return?

Don’t think that because you didn’t file a return that you will escape the IRS audit telescope. If you are in the IRS’s computer, the IRS will eventually request that you file—if the IRS can find you. If you ignore them, the IRS has the legal authority to file and, in effect, audit a tax return in your name. The Internal Revenue Manual directs the auditor to come up with a reasonable and substantially correct tax return—which gives the auditor a license for invention.

In addition to whatever information may be in the IRS records—typically income reports on W-2 and 1099 forms—the auditor may rely on tables from the Bureau of Labor Statistics (BLS) to estimate your income and expenses. This is often done when either the income sources on record show an impossibly small income, such as $4,000, when you live in a penthouse apartment in the Beacon Hill section of Boston, or when there is no income record at all. BLS data shows the government’s estimate of the minimum amount of income necessary to live on, taking into account your geographic area, family size, and probable standard of living.

To approximate income from a business, the auditor may rely on industry standards. For example, the auditor may use averages for sales and profit margin on all U.S. auto parts retailers to estimate how much Simon’s Auto Parts World made.

After the auditor’s report of a nonfiled return is completed, the IRS will forward you a copy. If you agree with the figures, you can sign it. If you don’t agree, you will be given an opportunity to dispute it with your own figures or to file a tax return. Or, the IRS will issue a Notice of Deficiency giving you 90 days to contest the IRS report in tax court. (See Going to tax court.)

Living Beyond Your Means

The IRS targets some people for financial status audits. These are special techniques to detect unreported income, including the UIDIF computer scoring program described above in “Computers and Classifiers.” The IRS looks to whether the income on the tax return supports the financial condition of the taxpayer. The IRS is looking for “economic reality” by approximating expenses for personal assets and living expenses. You might have to explain how you eat at the Ritz on a fast-food salary.

The IRS can’t randomly conduct financial status audits. Financial status audits aren’t to take place unless the IRS sees a “reasonable indication” of a likelihood of unreported income—a fairly vague limitation. (Internal Revenue Code §7602.)

How the IRS Investigates Your Lifestyle

You can understand the IRS’s focus on lifestyle audits by looking at the IRS training materials for auditors. They look at the following lifestyle-related issues.

The standard of living of a taxpayer:

• What does the taxpayer and dependent family consume?
• How much does it cost to maintain this consumption?
• Is reported net income sufficient to support this?

The accumulated wealth of a taxpayer:

• How much capital/assets has the taxpayer accumulated?
• When and how has this wealth accumulated?
• Has reported income been sufficient to pay for these items?
• If not, how did taxpayer obtain and repay credit?

The economic history of a taxpayer:

• What is the long-term pattern of profits and return on investment in the reported activity?
• Is the business expanding or contracting?
• Does the reported business history match with changes in the taxpayer’s standard of living and wealth accumulation?

The business environment:

• What is typical profitability and return on investment for the taxpayer’s industry and locality?
• What are the typical patterns of noncompliance in the taxpayer’s industry?
• What are the competitive pressures and economic health of the industry within which the taxpayer operates?

Other nontaxable sources of funds:

• Do claims of nontaxable sources of support make economic sense?
• How creditworthy is the taxpayer—how many claimed loans?
• How did the sources of claimed fund transfers obtain those funds? For example, it is unlikely that subsidies will be obtained from countries where dollars are hard to obtain.

Goal: Do the taxpayer’s books and records reflect the economic reality of his or her personal and business activities, or has the taxpayer omitted income in order to minimize tax liability?

Lifestyle Questions and Suggested Answers

The following sample questions are taken from IRS training materials. The suggested answers are strictly legal—and from me. Note that I never use the word no, but I don’t give the IRS what it’s fishing for, either. Unless otherwise noted, the auditor’s questions should relate to the year or years you are being audited for, not the year the audit takes place.

1Q. (If applicable) Can you show me a copy of your tax return extension for the past year?

1A. I don’t see how that is related to the year under audit. (It’s not.)

2Q. What is the educational background of you and your spouse?

2A. I don’t see how that is related to the year under audit.

3Q. What is the name of your previous employer and dates of employment?

3A. I don’t see how that is related to the year under audit.

4Q. Can I see the purchase documents on your home?

4A. Show only if you are claiming a casualty loss for your home, you sold it, or you are claiming a home office deduction.

5Q. What other real estate do you own?

5A. Show only if you are earning income from renting it or taking a depreciation deduction or other tax benefit from the ownership.

6Q. How many autos do you own, and what are the payments?

6A. If your cars are registered in the state of the audit, you might as well give in on this one as the auditor can easily check state records. Ditto with boats and planes.

7Q. Do you own any other large (over $10,000) assets?

7A. I don’t see how….

8Q. Did you sell any assets, and if so, for how much and to whom?

8A. Answer this only if you sold an asset, such as shares of stock on which you claimed a gain or loss, if there is a question about whether you reported enough income on your tax return to live on, or if the auditor asks the source of money deposited in your bank account. Otherwise, I don’t see how….

9Q. Did you lend anyone money?

9A. (Unless you had interest income from the loan for that year) I don’t see how….

10Q. How much cash do you have on hand at your home or business, in a safety deposit box or buried in the back yard?

10A. I don’t see…. (As a rule, never answer this question.)

11Q. Did you transfer funds between different accounts?

11A. Answer only if the auditor is questioning the source of deposits into your accounts. Otherwise, I don’t see….

12Q. Were you involved in cash transactions exceeding $10,000?

12A. This is a tricky one. If you say yes, then you may have had an obligation to file a Currency Transaction Report with the IRS; if you didn’t do this, you just confessed to a crime. If you say no, it had better be the truth, or you just broke an even more serious law. Stay mum or ask a tax lawyer how to answer if you are in doubt.

As the above hypothetical questions and answers indicate, try to answer economic reality questions with questions of your own, or don’t answer them at all. Politely remind the auditor that the questions don’t relate to the tax return, that you were merely selected for an audit, and that you shouldn’t be treated like a criminal. Suggest that if the auditor wants to make an adjustment based on economic reality, you’ll appeal. More likely than not, the auditor won’t call your bluff.

Market Segment Specialization Program

The Market Segment Specialization Program, or MSSP, is a cornerstone of the IRS process. The MSSP focuses on specific industries or groups of taxpayers believed to be in significant noncompliance with the tax law. Accordingly, the IRS provides specialized training to its agents and issues Audit Technique Guides for its auditors.

The IRS has made these Guides public —if you fall into one of the targeted categories, you will know what the IRS is after. So far, over 100 Guides have been issued on topics from architects to veterinarians. You can locate these Guides:

• at a law library
• from a tax professional
• by calling the IRS (at 800-829-1040), or
• on the IRS website, at www.irs.gov (search “Audit Technique Guides”).

Other Reasons for Audits

Besides getting picked by the IRS computer, there are seven—and in some years eight—other ways you can get into the audit soup:

Local projects. Local IRS offices can initiate special audit projects based on their perceptions of abuses by individuals and groups in the community. Recent projects include gamblers, people who claim excessive earned income credits, ex-spouses who deduct or receive alimony, and people whose mortgage loan applications show different income from what was reported on their tax return.

National projects. Every year, the IRS national office decides that certain occupations merit audit attention. Past favorites have included airline pilots and flight attendants, physicians, and morticians. Perennial targets are operators of cash businesses, such as bars and laundromats, food servers, cab drivers, and owners and employees of gambling establishments. This program is being phased into the MSSP audit, described above.

The IRS receives several clues to your occupation. W-2 and 1099 forms filed by others might indicate it. You are required to state it on your tax return. If you are self-employed, you must list a six-digit business identification code. Some people have tried creativity here, such as the prostitute whose return stated “public relations.” She was fined by the IRS and could have been criminally prosecuted when the auditor learned the exact nature of those relations. Misstating the source of your income is illegal, even if you report all of it.

Prior and related audits. Audit lightning does strike twice. Previous IRS audits often beget new ones—if they produced tax bills of at least several thousand dollars. But this is not a sure thing. I have seen people audited and hit with an enormous tax bill who never hear from the IRS again. If you are a partner, limited liability company member, or shareholder, and the business entity or any others in it are audited, you may not be far behind.

Criminal activity. Like grapes, trouble usually comes in bunches. If you are investigated for a drug crime or crime involving a lot of money, the IRS may be tipped off by the law enforcement agency and decide to audit. The tax code is morally neutral—it requires that all income, from sources legal or otherwise, be reported. The IRS doesn’t care if you made the money as a Mafia hitman as long as you declare it.

If you’d prefer not to disclose the source of income, you can file a Fifth Amendment tax return on which you claim your Constitutional right against self-incrimination. You enter the amount of your income on your 1040 Form and write Fifth Amendment next to the lines where you list the source and where the form asks for your occupation. While this may keep you out of the criminal investigation division of the IRS, it undoubtedly increases your audit potential.

Amended tax returns. You may file an amended tax return any time after you file an original one. The IRS has discretion to reject amended returns, but it usually accepts them. A few people file amended returns and wind up owing more in taxes, but most people amend their tax returns to get a refund. To get a refund, you must file the amended return within three years of the date you filed the original return, or within two years of the date you paid the tax. Because the IRS doesn’t like to give back money, it investigates all refund claims, sometimes by auditing. And if you are audited, everything on the return—not just the items amended—are fair game.

Filing an amended tax return doesn’t extend the time the IRS has to audit you—normally three years from the original filing date. So, the closer to the end of the three-year period you file the amended return, the less time the IRS has to audit you. But, the IRS has the discretion to reject amended returns and sometimes will accept them only on the condition the taxpayer agrees to extend the three-year audit limit.

Informants’ tips. Undoubtedly, you have heard stories about disgruntled ex-spouses, business associates, and former employees turning someone in to the IRS. While an audit could result, it should put your mind at ease to know that fewer than 5% of all audits result from tattletales. IRS sources say that most tips, particularly anonymous ones, are not seriously followed up. The IRS prefers to rely on its computers for audit selection. Historically, the IRS has found that many tips are not provable and are motivated by spite.

Where you live. Everyone knows that Kansas gets tornadoes, Florida gets hurricanes, and California gets earthquakes. Similarly, some locales get more than their fair share of audits. The audit rate is 150% higher than the national average in Nevada, but 150% lower than that average in Wisconsin. Other high-audit states are Alaska, California, and Colorado. Low-audit states include Illinois, Indiana, Iowa, Maryland, Massachusetts, Michigan, New York (excluding Manhattan), Ohio, Pennsylvania, and West Virginia. The second-lowest audit rate locale is the District of Columbia.

What’s more, how you come out of an audit depends on where you call home, too. Your chance of getting away without owing a nickel is more than twice as good in Las Vegas (32%) than in Manhattan (15%).

Random selection. The IRS is currently selecting some audit victims at random under its new National Research Program (NRP). These audits are reminiscent of the dreaded TCMP (Taxpayer Compliance Measurement Program) audits that were discontinued in the 1990s. The stated purpose of NRP audits is to gather data to update the statistical models used to score individual tax returns. Nevertheless, these are very “real” audits—in fact, they are much more intensive than ordinary audits.

Frivolous tax return. Claiming that your income is not subject to federal taxes is a surefire way to get on the audit list.

Political selection. It is a crime for a non-IRS employee to request that the IRS conduct or terminate an audit of a taxpayer. An IRS employee must report such a request to his superiors. (Internal Revenue Code § 7217.)

Continue to part 3