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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. peter says:

    There used to be a condition that the IRS would automatically audit you if you took too many deductions on your W4 (like 10+) – companies were forced to send in your W4s to a different dept for verification.

    i’m getting a $4-6k return every year despite filing married 10 due to high home mortgage interest, kids, and charitable giving. can i safely up my withholdings even further, or does the auto-audit flag on withholdings still exist? and if it does, what is the level?

    • James says:

      I have had my deductions set at 15 on my W4 for years, but because of kids (only 4), charitable givings, etc., I still get a small return each year. I do that so I keep my money throughout the year, and not give the government an interest-free loan. I have never been audited.

    • Brandon says:

      Actually, the condition is that your company may have to send in your W-4 for review if you claim more than 9 exemptions (http://taxes.about.com/od/preparingyourtaxes/ht/W4.htm).

      Also, there’s a limit on how many exemptions you can claim. I think it’s 12, and for everybody (I think) that will make it where no tax is taken out.

      If you get a return that is that large every year, you probably need to file for exempt status.

      • NCTaxPro says:

        Brandon:

        You can only get exempt status if you have no tax liability at the end of the year and don’t expect to have any the following year. When you get a refund, it means only that the amount you had withheld during the year exceeds the amount of your tax liability; it does not mean that you had no tax liability.

        • Brandon says:

          NCTaxPro:

          I understand that, but if Peter is getting a $4k-$6k return every year, then it might be something that he wants to look into.

          Here are the relevant instructions for a W-4:

          Note. You cannot claim exemption from
          withholding if (a) your income exceeds $950
          and **includes more than $300 of unearned
          income (for example, interest and dividends)**
          and (b) another person can claim you as a
          dependent on his or her tax return.

          If Peter is getting a refund of all of his Federal income tax every year, then he could file exempt. He’ll just get a smaller refund.

          http://www.irs.gov/publications/p505/ch01.html#en_US_publink10007250

          • NCTaxPro says:

            Brandon:

            You missed the other relevant part of pub 505 at the same link:

            “You can claim exemption from withholding for 2009 **only if both of the following situations apply**.

            For 2008 you had a right to a refund of all federal income tax withheld because you had no tax liability.

            For 2009 you expect a refund of all federal income tax withheld because you expect to have no tax liability.”

            No tax liability means that your gross tax due is zero *before* your withholding is taken into consideration. For most people, that’s not the case – if they had no taxes withheld they’d owe.

          • Brandon says:

            NCTaxPro:

            But wouldn’t you also need to take any applicable tax credits into account?

            This is the tax code we’re talking about, so it’s supposed to be complicated. :) It just makes more sense to me to use the equation

            (Tax at end of year) – (Credits) = Tax liability.

            Then, if your tax liability is less than or equal to 0 for the previous year, and it will be 0 for the current year, then you can file exempt.

          • peter says:

            just to clariy – i am not exempt. my total tax withheld is double my refund – i’m not being refunded everything, just a good, healthy amount.

      • NCTaxPro says:

        There is no statutory limit on the number of withholding allowances that you can claim on a W-4. However, the IRS can review your W-4, and very likely will if you are claiming more than 10 (single) or 15 (married). If the IRS determines that you are claiming too many allowances, they will send a letter to both you and to your employer. The IRS will order the employer to withhold based on the martial status and number of allowances specified in the employer’s letter. Furthermore, the IRS will instruct your employer to ignore any W-4 that you submit unless it results in more withholding than specified in the letter. You are allowed to dispute the IRS’s determination.

        The IRS provides a worksheet with the W-4, and it actually works pretty well in estimating the number of allowances that will bring you close to a zero-balance situation.

        • NCTaxPro says:

          Brandon:

          If line 60 of your 1040 – total tax – is zero this year, and is expected to be zero next year, then you can file to be exempt from withholding.

  2. Audited says:

    I was sent an IRS audit notice about 2 years ago. Apparently I did not report some of my many stock transactions. I was given 30 days to refile, pay the additional amount owed and penalty fee (forgot exactly how much but it was a percentage of the tax owed.)
    Fortunately I signed up for the audit defense so I just had to hand over my statements to the tax accountants and they handle all the paper work and dealing with the IRS on my behalf. Everything on my side was done via phone calls and emails.

  3. Kate says:

    My $50k full time job changed during the middle of the year to a part-time, $20k job. My boyfriend has been helping me financially with everything I can’t afford. In addition, last year I filed a 1099 but won’t this year because I didn’t get paid for any freelance work. Due to the difference does anyone this I’m more susceptible to an audit?

  4. Steve says:

    Everyone has the right to kids as long as they can afford them. Daniel, $25/hr with two kids and a wife that doesn’t work means you probably should have pulled out once or twice.

    • daniel says:

      Dave your comment is rude, off topic and senseless. this conversations was about tax deductions and tax audits.

      People used to have families and kids before this financial crisis, they did not expect that one of them or both were going to be unemployed for long periods of time having a good resume, that happen to more than one wife or husband in this country, tax deductions play and important role in the relief of those situations.

      you are lucky guy since is clear that you don’t have those troubles, and because your parents can not get back in the time, imagine all that tax returns that they could save to our country just following your advice and having your father pulling it out once or twice

    • Kat says:

      Steve, your comment is off-topic and quite frankly disgusting. To suggest that people with lower income “pull out” and not have children of their own is pigheaded and discriminatory trash. My husband and I have 3 beautiful children, whom we both have worked hard to support with NO help from government agencies such as welfare, even though I am sure we would qualify now that he got laid off from his job. How dare you sit up on high and look down your nose at those of us who have been violently shoved in to hard times and just happen to have kids. I hope your mother never hears of this post, else she might have a fleeting thought of what would’ve happened had your dad “pulled out”, if she hasn’t already! Jerk! And to anyone else that believes procreation should be for the rich, let me ask you this: Has your family always been rich? If not, then maybe some of you should’ve never been born? See my point yet?

      • NewPerspective says:

        Kat, although Steve is pretty crass, there is a point he’s making that’s valid. Whether rich or poor, a couple should be responsible for any children they bring into this world and not rely on the government to take money from other people by force and give it to them.

        From your response, it appears you’ve been responsible. I also have no reason to believe Daniel is irresponsible.

        Those that fall upon hard times through no fault of their own should turn to family, friends, church, charities, etc. The government should not be the solution to such issues as the government is not be a charity. Remember, whenever the government gives you (or anyone) money, it’s not pulling it out of thin air… it’s TAKING that money from someone else who worked hard to earn it.

        • daniel says:

          NewPerspective, I think you nail it, I work hard to feed my kids with no regrets at all, responsibility it’s the key and I’m intending to rise my kids on that core value, still I think that public education it’s a must be (people must learn to fish instead of beg for food), and I agree 100% with you when you said that “it’s hard for an individual to pay for services like police and fire on an a la carte basis”, I just bite the bait with the idea to make criminals pay for their tuition, security and custody what I think is just silly

  5. Kim says:

    I received a 1099 misc. statement that has the amount listed as #3-Other Income which is normally for winnings…I thought, but it should be earnings.
    I think I should put it on a schedule C like my other 1099s that are listed as #7-non-employee income…does it matter what business the 1099 comes from?
    Should I just lump all the 1099s together on a schedule C?

    • NCTaxPro says:

      Kim:

      Amounts reported in box 3 on a 1099-MISC are not normally subject to SE tax and should not normally be reported on Schedule C; they would ordinarily be reported as other income on line 21 of Form 1040. That said, if the issuer paid you for providing goods or services for which you typically receive a 1099-MISC with the amount reported in box 7, it’s likely that the issuer made a mistake (you’d be surprised home many people don’t know how to fill out 1099-MISC) and I would report the income on your Schedule C. The issuer should also issue you a corrected 1099-MISC.

      • Kim says:

        Thank you.
        I do freelance work and this work was for a gaming website that awards money to players. I just didn’t want to get audited because the of the type of website it was.

  6. Soccer9040 says:

    I’m a CPA and my taxes challenge me to think. I just dont know what the rest of the world does. I’m not a “tax” CPA, but I know all the basics and it just seems too confusing for the common person.

  7. Danny says:

    I have already filed through TurboTax (always use it) and my refund of $1,392 has been deposited into my bank account from the IRS.
    Does this mean I won’t be audited this year or is it irrelevant. Not worried, just don’t want the hassle.

    Thanks

    • billsnider says:

      It depends…….

      We don’t know much about you. You could have omited a bank 100-int or you over estimated your quarterly payments.

      bill Snider

  8. NCTaxPro says:

    Danny:

    It is irrelevant; there is no guarantee that you won’t be audited on this year’s return even if your return was accepted and your refund already deposited.

  9. terry says:

    Does the irs compare taxes from year to year, on corporation taxes, under 12,000.00 a year?

  10. trchel says:

    I am so upset.When we owe the IRS they take it ASAP. Now I did my taxes this year again as usual at jackson hewitt, and the IRS website and when I called the IRS. They have been telling me my refund would be in my account on March 16 2010. Well it is the 17th and it is not there. I called today and finally got someone. They said my refund has been in the Error resolution unit for 25 days.. Hello, why wasn’t I told this 25 days ago? I did the first time home buyers and I am head of house hold. Jackson Hewitt said they mailed all the forms in and my closing papers in. I am so confused.When I called the IRS today, the cust. serv, can not even tell me why it is in the error resolution unit. They said it says I will receive a letter in 2 weeks. What is the error resolution area? Do they do Audits? I wonder if me getting married on jan 3 10 has anything to do with it. My name is hyphennated on a lot of things, cause I had not got everything changed over by the time I did my taxes. But that should not matter should it? I asked Jackson Hewitt if they wanted a copy of my Marriage License, and they said no. What is going on? frustrated

    • Liz says:

      I have that same problem. I filed my return in January. After about 6 weeks I checked the “Where’s My Refund” section and it showed up. Then I checked the next day and it was gone. When I called after that I was told that there was nothing in the system and I need to re-file. I called today and was told that my tax return was in the error resolution unit for the same credit. I was also told that according to the system it took almost 2 months before my return was even received. I filed a second return and the gentleman helping me told me that could cause additional delays in processing (up to 15 weeks)!! What the heck is going on there?! I filed in advanced. It almost sounds like anyone who filed that credit is in that unit for review. Let me know how yours turns out.

  11. art says:

    can the irs audit you and after they investigate and say your good to go, then audit you again

  12. Hick says:

    I need to submit a 1040x to fix/switch from a Itemized deduction to a Standard deduction. Some of the documentation could not be found for my Itemized Deductions. After doing the 1040x, I owe about 100 dollars more then what the IRS already took out of my account. Do I just need to include a Check for the difference along with my 1040x when I mail it in, or do they send me a bill and I pay it then??

    • NCTaxPro says:

      Hick:

      Yes, you should pay the difference with your 1040X – and then the IRS will figure the additional penalties and interest you owe and bill you for that.

  13. DIVINE says:

    WELL I GOES LIKE THIS. I WAS 21 WHEN I HAD MY DAUGHTER. I WAS STILL LIVING WITH MY PARENTS WHO WAS RENTING THIS THREE BEDROOM APARTMENT. WHILE I LIVE WITH MY PARENTS, I PAID MY FAIR SHARE OF THE RENT. COME 2010 I MOVED OUT OF THEIR APARTMENT AND GOT MIND. WHEN THE IRS AUDITED ME, I WENT BACK TO THE RENTAL OFFICE OF MY PARENTS APART TO GET PROVE THAT MY DAUGHTER HAD SPENT AT LEASE 6MONTHS OF THE YEAR WITH ME BUT THEY REFUSE TAHT I NO LONGER LIVE THERE. THE IRS WANTS PROVE OF RESIDENCY AND THE APART IS REFUSING BC IM NO LONGER A CUSTOMER. WHAT IM I TO DO.

    • billsnider says:

      Do you have any rental recipyts or bills addressed to you? Ditto for other such stuff like bank statements.

      Bill Snider

  14. tammy taylor says:

    my house burnt last year. I have no idea how to get ahold of the tax forms that were sent to me that were also sent to the irs. I have lost 1099′s and only God and the irs know what forms I was sent that I am supposed to use on my taxes.
    Is there a way to find out shy of actually doing my return without them and then being audited by the irs because they weren’t listed.

    • billsnider says:

      I would suggest that you contact the IRS and tell them about your problem. Everything will work out in the end. The idea being that you don’t want to surprise the IRS. Get them to help you.

      Good luck and I understand your pain. It once happened to my daughter.

      Bill snider

  15. Crazymomma says:

    Me and my husband are legally married but had been seperated for about 5 yrs and had been filing taxes on our own as Head of Household, which gave me the EIC because I made less money than him. After reading some info on how taxes are suppose to be filed it’s got me worried we’ve been getting credits we aren’t entitled to. If we start filing jointly again will this put us in serious trouble with the IRS? Please HELP!!!!

  16. Crazymomma says:

    Any suggestions on how to fix our past returns?

    • Suzanna says:

      If you think made a mistake on a past tax return all you need to do is file an amended tax return for that tax year. It’s no big deal.

  17. Wondering says:

    The article tells us there is a score that the IRS uses, can we log onto their site and see this score to see if we have a higher or lower chance of being audited?

  18. Boston_Dude says:

    Weird situation, my friend just had a new born about 2 years ago but she got laid off from work and her unemployment checks stopped after the kid was born. So to help her out couple of us offered to give her $80/month if she come over and clean our house every other saturday. Because she reported the extra income the IRS now is auditig her and wants verification of the income. No big deal, but one of our friends is currently being audited for something else so because I am on the list of employers helping her out will I get audited too?

  19. Gene says:

    You are wrong, they do not collect taxes to help the working man, the collect it so all the people coming into the USA get everything for free, they are called free loaders. Time to stop it and really help our working people.

    • zapeta says:

      LOL. I’m sure your ancestors had millions of dollars when they came to this country and never needed any help from any kind of governmental agency.

  20. Alan says:

    Interesting summary of what goes into the algorithm.

    I have been audited three times in the last 10 years. Twice due to bonuses that the IRS questioned and once due to a stock transaction which I somehow recorded as futures transaction.

    • skylog says:

      agreed. i never really had a clue how the process worked. i can’t say that i had as much interest by the IRS as you did alan, but i did have one problem due to an error on my part. it was a fairly painless process.

  21. Everyone I know shudders at the very word “audit.” A friend of mine did get audited, and lost — and she appealed. Not only did she win her appeal, the IRS agent pointed out a couple of other deductions she could be taking.
    Although the experience was nerve-wracking, it had a happy ending.
    That said: I hope I never get audited.

  22. TLK says:

    Our C.P.A. firm is handling our first ever audit with the IRS. Previous C.P.A. at the firm left early this year. New one is now doing our stuff. Just found out the old one made several errors on 2008 and 2009 returns. Looks like (after 5 months of waiting for the final report from the IRS) we will be owing 20% interest and 20% penalties even though we had all of our documentation and explainations to the old C.P.A. She just didn’t do it right. How can we protect ourselves if we know nothing about tax code? We pay over 300/month to this firm to do our accounting. First audit in 32 years. She also claimed our ROTH contrib. as an 401k one. Big mistake on her part. This is a nightmare. We are now looking at over 6k in backtaxes and 4k in interest and penalties. There needs to be some responsibility taken by the C.P.A.’s.

  23. Anonymous says:

    my friend who main citizen is on sepain n he work in germany..n the tax officel make a mistake…his name is PIT not BIT, SO their mix up the account in tax and stolen all his $$ house,shop..to sAID HE DIDNT PAy THE TAX..HE PAY TAX IN SPAIN and never own any single sen in german…how can this be happen..and it take how long to get back the refund if he win the case??really a big mistake..ndo u think the govt willbe in trouble since their already sell his car,house n etc n said only give him 20% of d value..

  24. Anonymous says:

    THE IRS AUDIT TAX RETURNS TRUE ENOUGH THEY ARE AUDIT FOR MISTAKES THAT HAS BEEN MADE AND SOMETIME EMPLOYERS MAKE MISTAKE BY NOT HAVING 1099 OR W2 READY IN TIME FOR TAX SEASON. USING YOUR LAST PAY STUB IS’NT A GOOD IDEA EVEN THOUGH IT SHOULD BE CORRECT MOST ARE ‘NT CORRECT YOU WONDER WHY! BECAUSE EMPLOYERS OFTEN CHEAT THE IRS ON THE TAXES THAT NEEDS TO BE SENT IN ON A QUARTERLY BASES AND THIS WILL GIVE THEM ENOUGH TIME TO CORRECTED WHEN BUSINESS ISN’T WHAT IT SHOULD BE OR THAT THEY HAVE ENOUGH MONEY AT THE END OF THE YEAR. IF THIS IS INCORRECT THE 1099 OR W2 THEN AN AMEND RETURN SHOULD BE DONE. I HAVE MANY CLIENTS THAT MAY HAVE THIS ISSUE THAT COMES TO ME IN REGARDS TO THIS AND GENERALLY THERE IS SOMETHING THAT THE OTHER TAX PERSON MAY HAVE MISSED AND IT CAN BE CORRECTED. SO BE VERY CAREFUL WHOM DOES YOUR TAXES AND MAKE SURE THAT THERE EXPERIENCE IS WELL KNOWN.

  25. Anonymous says:

    the irs decided to do an audit on me for the year 1999 just this past 2009 , the year 1999
    was paid in full in 2008 because of some problems. why did we wait so long ? there were some theft cercomstances at the cpa office which resulted in the distroyedment of
    our records , anyway we managed to do an estimation from previous years advised by our
    irs agent who at the time was working with us
    now they are threatening to take my home my question is can they do this after the year has been paid in full and is the audit legit
    what can i do to have them erase this ridicules tax lean for this year i have proof of the tax lean release for that year when i paid it in full.

    thank you texas


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