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How Does the IRS Pick Tax Returns to Audit?

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Internal Revenue Service BuildingDoing your taxes is never fun. Even if you ignore how you must spend a couple hours filling out boring forms, finding documents, researching deductions, blah blah, there’s always the fear that you’ll be audited. I remember having the most vanilla tax returns back when I was a teenager, the 1040-EZ, and even then I was irrationally concerned about an audit.

The reality is that very few people get audited, just a percent or so each year (in 2010, 1.1% of returns were examined), and some of them deserve it. As much as we may like to think of the IRS as some cruel, emotionless monster trying to make the lives of hardworking Americans as miserable as possible, it’s not. They’re trying to collect tax revenue so the government can continue to provide the services hardworking Americans need.

How do they decide who to audit? It’s actually very straightforward.

In 2006, they published a page on the IRS.gov website that details exactly how they determined which tax returns to audit. It comes down to these four main ways (for individuals):

  • Computer Scoring – Tax returns are “scored” using two systems – Discriminant Function System (DIF) and Unreported Income DIF (UIDIF). The Discriminant Information Function System (DIF) score gives the IRS an indication of the potential for change in taxes due, based on past IRS experience. The Unreported Income DIF (UIDIF), as you can imagine, scores the return on the potential for unreported income. The higher the score, for either, the more likely the return will be reviewed.
  • Information Matching – This is an obvious reason because it’s the easiest to catch. The IRS receives the same W-2s and 1099s that you do, so it’s trivial for them to compare the two totals. If they don’t match, they investigate. Usually the investigation is simply a CP2000, rather than a full blown audit, because the problem is easy to catch and correct.
  • Related Examinations – Beware who your friends/business contacts are! If their returns are audited and their return includes transactions with you, your return may be audited as well. The reason this makes sense is because if their return has a problem, the correction may involve your return. You may not be audited but you may receive a request for clarification.
  • Potential participants in abusive tax avoidance transactions – The IRS may get information about promoters of and participants in various schemes and select a return for audit based on that information.

Most of the red flags you read about fall into one of the first two categories. For example, if you under report your income, you could trigger both the UIDIF score and the information matching reasons. If you participate in an abusive tax avoidance transaction and the guy who plans it gets caught… you’ll probably get audited. :)

(Photo: afagen)

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135 Responses to “How Does the IRS Pick Tax Returns to Audit?”

  1. Chris says:

    If major errors are found, does the accountant ever take any of the heat. You always see celebrities getting busted but what about their accountants?

  2. NCTaxPro says:

    Chris:

    IRS makes it very clear that it is the individual taxpayer who is ultimately responsible for the information that appears on his/her tax return. If you hire someone (whether it be a CPA, professional tax preparation service, or your friend down the street) to handle your tax affairs, it is YOUR responsibility to understand what is being done on your behalf and to ask questions if you are not sure.

    • Russ says:

      NCTaxPro is correct. And may I add, that most will pay for penalties if the mistake is theirs. The additional basic tax due would have been paid by you anyway, if the mistake hadn’t been made, so it’s generally bad manners to complain about paying a tax amount you already owed, but hadn’t paid due to a tax preparer’s error.

  3. Christine says:

    If it is a major error on the part of the accountant, professional liability should cover it and now there are rules in place so the accountant cannot claim “I’m just reporting what the client gave me and I did not know” the accountant can now be fined.

    • Strebkr says:

      Everyone seems to try to wash their hands of anything that smells bad. The accountant will just say “I reported what the client gave me”, and the client will say “hey thats what I pay an accountant for. How was I supposed to know I couldnt deduct that”

    • Jennifer says:

      Can you supply me with the information or which direction to go with this, “now there are rules in place so the accountant cannot claim “I’m just reporting what the client gave me and I did not know” the accountant can now be fined.” The EA that I used for 3 years attached all of my W-2′s and sent them into the IRS but failed to type in the numbers when preparing my taxes. When I receive the audit letters and talked to the EA about it she laughs and says” oops, I forgot to add that, oh well, you have to pay it.” she will not take any responsibility!! I supplied her with the information. SHe has made it quit clear nothing can happen to her. I understand I owe the money, but this is gross incompentency on her part. What can I do?

  4. There’s also a big difference between “errors” and “fraud”. If you forget to include a 1099 for $100 in interest, the IRS isn’t going to try to throw you (or your accountant) in jail.

    If you’re washing your money through some sketchy off-shore tax shelter, they may indeed try to have you both incarcerated.

    • saladdin says:

      On that same note of fraud vs errors. I hear friends that believe that they can’t be audited after X number of years thinking there is some SOL on fraud.

      saladdin

  5. zapeta says:

    Good to know the reasoning. All I can do is put in the right numbers and hope for the best!

  6. Chuck says:

    In the “IRS is not a cruel monster” topic, I’ve always thought of the IRS as a victim. They have to interpret and implement the tax code (very huge and contradictory) while minimizing the burden on the taxpayer (paperwork reduction act, et al.). They’re lucky if they can get that right, but I think they do a pretty fine job of it.

    • So, what, you’re saying congress is to blame?

      That’s just crazy talk!

      ;)

    • valletta says:

      You obviously haven’t been audited!

      My husband and i opened a business at the end of 2000. We had already paid significant tax withholding from our previous jobs in early 2000.
      When my accountant came back with our 2000 return which said we were getting a $50K refund we were ecstatic.
      Such began our nightmare.
      The IRS has three years to DECIDE if they want to audit you. I begged them to audit us so we could get our refund. No go. They waited for 3 full years, THEN audited us. It came back clean. They refused to pay out and RE-AUDITED. We had opened a business and badly needed OUR money back. I felt like I was in Kafka’s “The Trial”.
      The IRS does not use faxes or emails and you cannot talk to the same person twice. I spoke with 50+ different people, with no added value. I had to repeat our story EVERY time.
      They would not let me hand deliver documents to expedite our case (after 3 years!)
      I now understand why some people crack. I almost did.

      • NewPerspective says:

        I’m confused… Why did you need to be audited to get your $50K back? Wouldn’t you be refunded automatically after filing your taxes in Apr 2001? Or is an audit required if the refund is over a certain amount? Sorry… this question is coming out of ignorance on my part, but I genuinely am curious!

      • portwineboy says:

        Valletta – contact the IRS Taxpayer Advocate office.

        These IRS employees are trained to take your side in tax disputes that get confusing.

        http://www.irs.gov/advocate/

      • gabrielle s says:

        But what if your tax papers got runed? Do you know what too doo?

  7. tbork84 says:

    Thank heavens for some of the simple forms. Tax filing is terribly complicated for those who don’t get W-2′s, and I am glad not to count myself among them. Yet that is.

    • NCTaxPro says:

      tbork84:

      Tax filing isn’t necessarily complicated for those who don’t get W-2s, if they keep good records of their expenses against that income. And tax filing can be complicated for those who DO get W-2s, if they happen to do such silly things as exercise stock options or have the compnay pay them for child care expenses, and if they don’t realize how that income is to be reported to the IRS.

  8. Toni House says:

    There is really no reason to fear being audited. It is simple really. If you take the time necessary to gather your information, all income, all documents, all expenses and all documents to support your deductions and you keep them for up to 3 years and some documents for up to 7 years. An audit can be painless. Be organized on the front end saves time and losts of your hard earned money on the back end.

    • Gopher Baroque says:

      I agree; I just fill out the tax forms with the thought of “what documentation would I provide to explain my claims” in mind and save that paperwork in my files.

      The closest I’ve come to “audit” was a letter from the IRS that they came up with a different conclusion about a “hard to dig out the right numbers from ancient history” cost-basis from selling some stock that I got as a gift (thanks, dad!). I just paid a few more tens-of-dollars to agree with the IRS and nothing more came of it.

  9. eric says:

    I hope I never encounter an audit!

  10. jsbrendog says:

    coworker of mine was a 1099 freelance worker for our company for the past 3 yrs and never paid taxes. now he was hired full time in 09 and will HAVE to file this year with his w-2…that should be interesting…

    • NateUVM says:

      Wait, he NEVER paid ANY taxes?!

      Perhaps you should read Jim’s article, “How to Report Tax Fraud and Tax Cheats.”

      • JRBeaman says:

        It isn’t fraud or cheating. You obviously know very little about the definitions of words.

        If you don’t file, what are they going to audit?
        If you don’t sign a document of any kind, you have no contract obligation.

        It’s not fraud or cheating unless you file with known bad information.

        Tax evasion is illegal, tax avoidance is not.

  11. Maddhatter says:

    Interesting article…just need to keep out of the “toxic waste”.

  12. Tax Guy says:

    In Canada, the audit process is risk based. Those who have the greatest opportunity to make mistakes that are significant are more likely to be audited. The risk base also targets certain industries: i.e. construction trades people.

    Now there are fewer deductions available here and the typical person receiving employment income will probably never get audited since there are few if any discretionary deductions.

  13. billsnider says:

    The message to anyone who files a tax return, make every effort to learn and understand what you are doing.

  14. NateUVM says:

    Just figured I’d post about an instance where I was the benficiary of a review by the IRS.

    You may all remember the 2nd Bush tax cut from 2008? Well, my wife and I got our refund check so early in the process that, when we were doing our taxes for that year, we had no idea that we were due an additional refund for our child….who was born about 8 months after we got the first refund. We had no idea we were even eligible. No idea, that is, until about a week after we filed.

    So, I got down to preparing to file an amended return. That, however, became unneccessary when I checked my account one day and found that the IRS had already sent me an additional amount to cover the refund that I hadn’t even filed for! They had automatically reviewed my return and saw (perhaps automatically) that I was actually owed MORE of a refund. Saved me a lot of time that I would have spent filing an amended return.

  15. hoht says:

    A-U-D-I-T… makes a very cold chill down the spine.

  16. Shirley says:

    We were audited for the year 1962. Our second child was born in early 1963, but since the doctor/hospital predicted costs had to be paid in advance (I don’t think they do that anymore) they were paid and claimed in 1962. There was not an additional child claimed for that year.

    Give the IRS credit for this one: in checking our receipts, they found some that we hadn’t claimed and our return was increased. We didn’t get the check until November, but it was for more than we had claimed. :-)

  17. Izalot says:

    I heard through the rumor mill that having a home-based business is a huge red flag for auditing and having the IRS come knocking at your door!

    • Patrick says:

      Having a home-based business isn’t a red flag in and of itself, but the deductions you take can lead to an audit.

      I’ve had a home-based business for 3 years now, but I don’t claim a home office because the room is also used for other activities. I also share some items between personal and business use and can write off a portion, but not all of those items (for example, printer, computer, etc.).

      If you use a dedicated office you can deduct the value of that room (either rent or home depreciation) as well as a proportion of your utilities related to the size of the room.

      Obviously the more deductions you take and the larger they are, the more likely they are to receive attention from the IRS. Just keep receipts of everything and run it through the smell test before including it on your return. If it sounds sketchy, clear it with an accountant first, otherwise leave it out.

  18. Jim that’s for the information. I always find that you do great thorough research. I never knew what the process was, this was a very enlightening post.

  19. David says:

    “They’re trying to collect tax revenue so the government can continue to provide the services hardworking Americans need”

    so your sayin the government can spend your money better than you can

    • Jim says:

      It’s hard for an individual to pay for services like police and fire on an a la carte basis. As you race out of your home during a house fire, do you want to remember to get your credit card so you can pay for the fire truck? Do you get one truck? two? How many firemen/women do you want?

      It’s an absurd scenario but a potential alternative to the one we have now of taxation.

      • David says:

        If your house is on fire then you call the fire department to put out the fire. Once the fire is extinguished then you pay the fireman $200 or $400, its small price to pay for savin ur house.

        The people who commit crimes should pay for the police. If the police can catch the thief then he gets paid if not then he doesn’t get paid.

        As for schools, people should pay for their own kid’s education. If they can’t afford to pay then they should not have kids, birth control.

        There is no difference between taxing money from people and stealing money from people.

        • NateUVM says:

          If no one paid any taxes that supported, say, fire departments, then the cost to extinguishing a blaze at your home wouldn’t be a mere $200-$400. How, exactly, is that going to pay for all the training, gear, supplies, housing, salary(including hazard pay), etc… for the fire fighters?

          No, without looking at the numbers, I think that might come to more like $50,000-$100,000 per fire. Maybe I’m overestimating, here, but the point is that the marginal cost of putting out a fire is WELL in excess of what any sane person is going to want to spend to have it put out on their own.

          No, rather, these services act a LOT like insurance. We all pool our resources so that, heaven forbid, if we need them, they are there in a well-maintained fashion, to help us out in our time of need.

          Bottom line, feel free to pull out of the system, but don’t expect anyone to come running with anything more than a bucket if your house is on fire and you’re only offering a couple hundred dollars to cover the cost.

          While it is true that, “the ability to tax is the ability to kill,” the argument being made here is a little ridiculous.

          • Newtothissight says:

            I pay property taxes for education and fire. I had a flood in the area, the local fire department told me it would be 2 days befroe they could pump the 30″ of water out of my basement. I had to hire a plumber so much for the government providing services.

        • Cigamit says:

          I saw a story a few days ago, but can’t find it now (but will keep looking). What most people don’t know is that when you have a house fire, your insurance actually pays for the fire fighter services (at least here in Texas). The story I was looking for was of a Texas family that got a bill for $17k for the services rendered when their house caught fire and they didn’t have insurance.

        • Bill says:

          I agree with David! I would also like to add that any deductions for children ages K-12 be removed as well as child care. Why should the parents get a tax break yet use the resource? If you cant afford to pay the price dont have a child.

          If you really want to stir the pot lets add a tax for persons with children in public school. A schooling tax. the Govt. adds say 2K to your tax bill for every child in public school. If you do home school or private school you dont pay the schooling tax but you also dont get a tax break. There would never be a problem with funding for schools!

          I also think the prison system could benefit if the prisoners had to pay for there stay in prison! They earn there money by working. There wouldnt be one pot hole in any street and our roads and highways would be spotless of liter!

          • daniel says:

            Bill, I make $25 hour and I have hard times covering all my family bills (my wife does not work, two kids), I understand your point, but people with low education or unemployed also have the ethical right to rise a child, kids are not just for rich people don’t you think?

            public schools is what allow people coming from low income families to get a better life (example mr Obama)

            About the prisons, system make the prisoners work, it’s just that security and legal cost are quite over what they produce

            so if an airplane hit your house who pays?, the terrorist that took the airplane, the airline, the government?, the home land security, your insurance, the pilot? that’s the kind of situation when taxes and government are welcome

          • VincePeterson says:

            Bill, I’m thinking that if we gut educational funding support even further, the prison population would explode.

            According to your logic, I’m assuming you’re either wealthy or childless.

            But I’m glad that you and David agree with me that the Pentagon budget should be eliminated!

        • JadeStar says:

          What a load of nonsense… the fire department doesn’t even save the *house that’s on fire*… they save the *neighboring houses* from catching fire by extinguishing the one that’s burning!!!
          So, with your logic, the neighbors are the ones who should shell out the cash to pay the firemen. Why should I even call, when my house is already toast?

          And who would pay to put out brush fires started by lightening, which threaten entire neighborhoods and towns?

          Incidentally, although we pay small taxes for police, people who are *caught* for crimes generally face financial penalties in addition to any other penalties and loss of freedoms, which is direct revenue for the justice system. Bail, for instance: Parking Ticket? $60 Speeding Ticket? $150-300. Stealing? $500+ Drugs? $2k-10k+ Murder? $1M seems to do it. Jail inmates are often used as cheap labor to provide revenue for the jails, and let’s not leave out those monthly payments for probation and parole supervision… so YES, caught criminals pay for crimes, lazy police departments get less revenue, and quiet areas have tyrannical police who would otherwise be revenue-starved and lose jobs (Re: speeding tickets in small towns! Incarceration of non-violent drug offenders!).

          How would we pay for highways without taxes? Should every road be a toll road? Seriously, *every* road?? What about the plumbing systems, drainage systems, tornado/hurricane sirens? Would you throw away parks? Art museums?
          Who would educate the poor about birth control, in your scheme (duh, the uneducated are the least likely to know anything about it)? Who would pay for non-commercial scientific development which brings better understanding of nature… like the kind that comes up with understanding about birth control and nutrition, disease *prevention* (rather than prescription drugs)? Who would pay for even a small army for defense?

          Are you offering to foot the bill on these things personally? I’ll happily take a refund check from *you*, if that’s what you’re suggesting.

        • Glenn Emery says:

          Wow David…Just wow….

      • saladdin says:

        And what if the last time you needed the police you were short and could not pay, do they ignore your call the next time because you still owe them?

        saladdin

      • NewPerspective says:

        Jim, in all fairness, I laughed when I saw that statement too. Keep in mind that the IRS collects federal taxes. Local taxes pay for fire/police. Federal taxes are generally taken from hardworking Americans and given to those who don’t work. With the exception of national defense, we receive few “services” from our federal tax.

        • daniel says:

          few services as, emergency funds for disasters, defense, laws, and billions for the financial meltdown crisis relief, unemployment, etc a million of times, I’m not saying that the government is perfect using the federal taxes collected but is the smaller pain, we should be talking instead about what’s the best way to wisely use those funds back to the people

          • NewPerspective says:

            Let me correct my comment…

            “We receive few services allowed by the Constitution beyond national defense.”

            LOL

        • Anonymous says:

          Taxes pay for roads, schools, etc. Do you drive? Even if you don’t have childen in school, it’s ignorant to suggest the U.S. downgrade the public school system. Education is the key to our future (the entire country). If you would prefer to pay less taxes and live in an uneducated society, maybe you should consider moving to another country.

          • NewPerspective says:

            My comments were specifically about “federal” taxes – not local.

            With the exception of the Interstate system, local taxes pay for roads. I would classify the Interstate as “one of the few services” I mentioned above, and it rightly falls under the Commerce Clause of the Constitution.

            There is no constitutional authority for the federal government to be involved in education. Historically it has always been paid for by local taxes (primarily property tax here in Colorado). It is not a “service” the federal government provides.

      • NewEnglandDevil says:

        In addition to the previous comments, it may be of interest to you to know that over 70% of all firefighters in the nation are volunteer firefighters. While taxes still cover the purchase and maintenance of equipment, salary and benefits for a chief and for training, the onerous costs associated with unions, pensions, disability fraud, etc. are not an issue for most of the nation, who pay much less in local taxes as a result.

        • saladdin says:

          I live in a rural area. There is some type of “fire ranking” for insurance that having a volunteer fire department lowers which means lower premiums.

          saladdin

      • JRBeaman says:

        The Subject is about IRS audits, not local taxes.

        The IRS does not collect any taxes for police and fire. That is done by the state.
        Your: “alternative to the one we have now of taxation.” is also false because, again, the taxes you pay the IRS does not go to any of these services.

        Why does everyone think their roads, and schools, and police and fire, etc. are paid for by the Federal Income Tax? Roads are paid for by gasoline taxes, schools police and fire by property taxes, plus a bit of added on sales tax.

        The federal government gets most of the money in some cases, and spreads it around more evenly, after they take some for deciding who gets what, but still, the income tax does not pay for any government services.

        Notice you pay the IRS, but refunds come from the Treasury. If you follow the money, you will find that the income tax goes directly to pay the interest on the national debt.

        I have researched this extensively, and debunked every belief that you get some ‘service’ for this money. What the IRS collects from the ‘graduated income tax’ (they collect taxes for other things too) does not even cover the overhead of running the IRS. What that means, is that most of us pay the IRS for beating us up for the money, and nothing more.

        Think about it.

        One other note. The Income tax is not a tax on income. Yup, cause that would be unconstitutional. It is a tax on certain activities that are controlled only by the federal Government. The amount of tax paid for this is based on your adjusted income.

        If you work, say in AZ and live in AZ, nothing you are doing is a Federally controlled privileged activity.

        But, they get away with it because everyone is told they have to, and hardly anyone ever looks to see if it true. The courts also go along with it under federal pressure, and juries will find you guilty out of embarrassment to admit they have been swindled for years and want to get even with you because you didn’t pay your fair share of the extortion money.

        CPA’s are licensed and “tax accountants” are trained by the IRS on how to collect the right amount of money, should you chose to pay it. They never get schooled or learn where the law says you are liable. Why would they?

        I like to think of the average person paying the income tax, as being under mass hysteria.
        Under the influence of ignorant peer pressure.

        But don’t get me wrong, if you choose to pay it, for what ever your reasons, go ahead, and be sure you do it right, because your signature on a 1040 is a legal contract to voluntarily keep paying accurately.

        • mikestreb says:

          Say Hi to Richard Hatch when you see him in prison…

        • mikestreb says:

          The IRS collected $1.1 TRILLION DOLLARS last year in Individual Income Tax… You saying that entire amount went to the National Debt??? I think it would have been paid off by now if that were the case.

          Also, I am a Tax Accountant and I never received any ‘IRS Training.’ Must have missed that class in college…

      • JRBeaman says:

        The income tax does not pay for any government supplied service except to beat you up for the money. If you think otherwise, you are ignorant. If you think I am wrong, then reply and I will correct your ignorance.

  20. It’s always scary of the thought that you may get audited. At least it’s pretty refreshing to know as long as we are honest on our returns there is only a small chance of still getting audited.

  21. Zahid Lilani says:

    As a tax accountant I come across a lot of folks who just think they know what they are talking about. My job is to take their word if they say that they have a receipt/documentation to support their claims. That is one reason we make them sign the tax return.

    I see lot of taxpayers blaming their accountant and tax preparers for being audited but it is really not their.

    Don’t shoot the messenger and stop thinking that IRS is stupid.

  22. ebekele says:

    Jim that’s great info, thanks! But where were you 3 years ago :) I was audited for capi gain, even though it was reinvested. Guess I missed couple of items :)
    Process wasn’t as bad as I thought it would be.

  23. I agree with billsnider! The best thing you can do is understand your personal tax situation and be organized with your documentation.

    Jim – great post – thanks!

  24. Connie says:

    I get audited every year, like clockwork. Last year I was audited on 3 different aspects of our return. I live in Canada but I bet the procedure is the same. I don’t even get scared anymore. I know I haven’t done anything intentionally, and I am really careful so I don’t make many mistakes. They are wasting a bunch of time on me. But so be it, it is their time to waste.

  25. Olivia says:

    My dad was a sculptor and worked many small teaching jobs in any given year, besides selling sculpture. He had a tax guy do his taxes one year who set up his equipment purchases on a depreciation basis. A very bad thing. He was audited, had to pay huge penalties, and still was clueless as to what happened. So the upshot is, if you’re severely right brained, and if someone has to do your taxes for you, find someone who’s familiar with the ins and outs of your particular field.


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