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How Are Tax Returns Selected for Audits?

It’s useful to understand how tax returns are selected for audit by the IRS. Many possibilities of reasons why business [one] get audited by the IRS, but this post try to give some sound reasons for the question. By the way, if you are audited, you are entitled to know why you were selected. You ordinarily have to ask to find out.


Tax Returns Got Audited Because Of Bad Luck

Bad luck sounds likeno-brainer”. But here are the facts:

A certain number of tax returns are randomly selected for audit every year. For example, the IRS announced in 2005 that it planned to audit 5,000 randomly selected S corporation returns from 2003 and 2004 as part of a National Research Program study to assess the reporting compliance of S corporations.

As if this wasn’t bad enough, in 2007 the IRS announced that it planned to launch a new National Research Program reporting compliance study for individual taxpayers. The purpose is to provide updated and more accurate audit selection tools and support efforts to reduce the nation’s tax gap. Starting in October 2007, the IRS will randomly select about 13,000 individual returns each year to be audited as part of the program. IRS examiners will look for unreported income and overstated deductions or tax credits, focusing on Schedule C filers. If you find yourself in these categories, there’s not much you can do about it. As long as you have adequate documentation to support your deductions, you should do just fine.

Tax Returns Got Audited Because Of Having High DIF Scores

One way the IRS decides who to audit is by plugging the information from your tax return into a complex formula to calculate a “discriminate function” score (DIF). Returns with high DIFs have a far higher chance of being flagged for an audit, regardless of whether or not you have done anything obviously wrong. Anywhere from 25% to 60% of audited returns are selected this way. Because the DIF formula is out of date, fully one-third of audits conducted in recent years through the formula resulted either in no change or a tax refund. The IRS is in the process of revising the DIF formula to achieve better audit results. Exactly how the DIF is calculated is a closely guarded secret.

Some of the known factors the formula takes into account are:

  • Where you live. Audit rates differ widely according to where you live. In 2000, for example, taxpayers in Southern California were almost five times more likely to be audited than taxpayers in Georgia. The IRS no longer releases information on audit rates by region, but according to the latest available data, the state with the highest audit rate is Nevada; other high-audit states include Alaska, California, and Colorado. Low-audit states include Illinois, Indiana, Iowa, Maryland, Massachusetts, Michigan, New York (not including Manhattan), Ohio, Pennsylvania, and West Virginia.
  • The amount of your deductions. Returns with extremely large deductions in relation to income are more likely to be audited. For example, if your tax return shows that your business is earning $100,000, you are more likely to be audited if you claim $50,000 in deductions than if you claim $5,000.
  • Hot-button deductions. Certain types of deductions have long been thought to be hot buttons for the IRS —especially auto, travel, and entertainment expenses. Casualty losses and bad debt deductions may also increase your DIF score. Some people believe that claiming the home office deduction makes an audit more likely, but the IRS denies this.
  • Businesses that lose money. Businesses that show losses are more likely to be audited, especially if the losses are recurring. The IRS may suspect that you must be making more money than you are reporting—otherwise, why would you stay in business?
  • Peculiar deductions. Deductions that seem odd or out of character for your business could increase your DIF score—for example, a psychologist who takes huge depreciation deductions for business equipment might raise a few eyebrows at the IRS.
  • How you organize your business. Sole proprietors get higher DIF scores than businesses that are incorporated or owned by partnerships or limited liability companies. As a result, sole proprietors generally are most likely to be audited by the IRS. Partnerships and small C corporations are ten times less likely to be audited than sole proprietors.

IRS Income Matching Program

For example: assume that you are a professional and your clients may have to report their payments to you to the IRS on Form 1099-MISC . IRS computers match the information on 1099s with the amount of income reported on tax returns. Discrepancies usually generate correspondence audits.

A 1099-MISC need not be filed by a client when you perform services for a client’s business—for example, a lawyer represents a company in a lawsuit, or an accountant audits a business. Nor does a 1099-MISC need to be filed when you perform personal services for a client or patient—for example, a doctor operates on a patient, a lawyer writes a will for a client, a psychologist gives therapy to a patient, or an optometrist fits a client with eyeglasses.

In addition, a 1099 must be filed with the IRS by a client only if the client pays you $600 or more during a year for business-related services. It makes no difference whether the sum was one payment for a single job or the total of many small payments for multiple jobs. Payments for merchandise or inventory don’t count for purposes of the $600 threshold.

If you’ve incorporated your practice, the general rule is that your clients need not file any 1099s, no matter how much you are paid. However, there are two big exceptions: Payments to medical corporations and payments to incorporated attorneys must be reported on Form 1099. But, remember, this is required only if the services are provided for a client’s business.

Groups Targeted for Audit

Every year, the IRS gives special attention to specific industries or groups of taxpayers that it believes to be tax cheats. As mentioned above, IRS favorites include doctors, dentists, lawyers, and CPA s. The IRS also targets taxpayers who use certain tax shelters or have offshore bank accounts or trusts.

Tips and Referrals

You could also get audited as a result of a referral from another government agency, such as your state tax department. The IRS also receives tips from private citizens—for example, a former partner or ex-spouse.

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