Audits aren’t fun. They can be costly and very time consuming. Often the clients who fear them the most are the ones who are least likely to get audited. Let’s take a closer look at how the IRS determines who to audit.
The IRS uses a variety of methods to select returns for examination. The agency actively works to identify promoters and participants of fraudulent tax avoidance transactions. If the IRS receives information indicating that you may be a participant in such a transaction, your returns will likely be examined.
The IRS also uses a computer scoring system based on the information gathered from the research audits. The Discriminant Function System (DIF) score rates the potential for change and the Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income. The formulas that are used to calculate these scores are kept very confidential—even people inside the IRS don’t know exactly what they are. When you have an item on your return that is outside the norm, it’s flagged by the computer and a person takes a look at it and determines whether or not it needs to be examined further.
A classic example is a return that shows very little income and a lot of interest and expense deductions. The IRS is going to want to know what that person is living on and the return can be stamped for examination. The return could be totally legitimate—perhaps a person who recently lost a high-paying job is living off savings or has moved in with a family member, so he has virtually no day-to-day living expenses and is trying to meet his obligations from when he had a higher income. Or it could be that the person is in a cash business and is trying to avoid paying taxes by not reporting all of his income—in that case, the IRS is going to attempt to uncover the truth and take appropriate action.
Or a taxpayer might take charitable deductions that are higher than the norm. Someone at the IRS will review the entire return and decide if the charitable deductions look reasonable in the overall context of the return. If so, the taxpayer will never know his return was reviewed. If not, he’ll likely get a letter asking him to document the charitable contributions.
Returns may be selected for audit when they involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for examination. And some returns are identified for examination in connection with local compliance initiatives, specific market segments, or return preparers. Finally, some returns are selected for audit based on reports of suspected fraud. These reports are often made by former spouses, disgruntled employees, or someone you’ve ticked off for some reason.
How Are You Notified that You Are Being Audited?
You will always be notified of an audit in writing by regular U.S. mail. A revenue agent could possibly follow up with a phone call to set up the date of the examination. During the call the agent will not ask you for any information about your tax return or to discuss anything other than setting up a mutually convenient time for a meeting. The tax compliance officer or revenue agent will probably say something like, “Hello, my name is John Smith with the Internal Revenue Service, and I’ve got your 2016 return for examination. I need to set an appointment with you and I will be following up this call with a confirmation letter. Can we schedule a date and time?” Once you agree on a date, time, and place, you’ll be off the phone. The agent will verify your mailing address, but will not ask you any other questions.
You will never receive an audit notification by e-mail. The IRS never initiates any communication via e-mail, but they can receive information from you via email. If you receive an email from the IRS it is not legitimate and is likely simply an attempt to defraud you in some way.
Always respond to an audit notification by the deadline, even if you need additional time to gather the information requested. If you fail to respond to a correspondence audit, you will simply be assessed the tax on the item in question. If you fail to respond to an office or field examination, you risk the agent doing something known as stripping the return, which means all of your expense deductions are removed from the return and you are assessed the tax on that basis.
Taxpayers should take all steps to avoid an audit. I have seen certain audits go on for years. If you are being audited, make sure that you reach out to a tax professional so you can understand the process and your rights under the law.