Avoiding an IRS audit (part 1 of 2)

The first defense against an IRS audit is to avoid them in the first place – and knowing how IRS audits are triggered in the first place can equip you to take steps to avoid them. The secret IRS program

The IRS runs a top-secret computer program (the “discriminate income function” or DIF) that analyzes the millions of tax returns filed each year. The program has been developed over many years based on research studies performed by auditing selected returns in varying industries with differing attributes, and carefully analyzing the results to determine which returns are most likely to produce a positive cash flow to the IRS. That is, what characteristics on a tax return indicate that the Service is more likely to collect more than enough income tax to justify the cost of the audit. In other words, find the big trees with low-hanging fruit. The higher the DIF score, the

After the IRS computer “kicks out” the returns with the top DIF score (roughly the top 10%), the returns are screened by IRS personnel. This personal screening process pares down the selection subjectively based on the judgment of the screeners. Human screeners are capable of much finer discernment than the computer, and they eliminate returns containing high DIF features that nonetheless appear reasonable and appropriate to the human screeners. For example, a large deduction for “party balloons” which triggered a high DIF score might be evaluated as unworthy of audit by a human screener if it appeared on the return for a birthday clown or new car dealer, but would more likely look like low-hanging fruit on the return of a mortgage broker.

Jan, an accounting clerk making $25,000 in wages and who claims the standard deduction, is not likely to get an audit letter.   The income is well documented by the employer, so there is little opportunity for the taxpayer to be under-reporting income, and the standard deduction is automatically available for any person who takes a single breath in any tax year. The Service is not likely to generate any revenue from auditing Jan. Carmen, however, a dentist who earned $300,000 in her practice and who claimed 55,000 business miles as a deduction, is a much more likely candidate. Not only is the 55,000 miles excessive compared with other dentists (indicating that an adjustment may be made resulting in additional tax) but Carmen makes a lot of money so she will have the ability to pay the additional tax assessed. The computer program is much more likely to select Carmen (in fact, certain!).

While the exact contents of the DIF program are unknown, accountants over the years have learned to identify certain characteristics of tax returns that have been audited that re-appear frequently and are most likely to have increased the DIF score:

1)      The higher the income, the higher the DIF score. The Service does not want to waste time auditing taxpayers who would just end up in Collections, so low-income taxpayers generally get a lower DIF score. One exception to this is taxpayers receiving the Earned Income Credit, a welfare payment to low income parents, which is subject to a lot of abuse and generates a lot of

2)      Failing to include income reported by 3rd party payers increases the DIF score.

3)      If your deductions do not match 3rd party reporting (e.g., you report $39,000 of alimony paid but your ex-spouse only reports receiving $29,000) or if your deductions are excessive in relation to the other items on the return (55,000 business miles would be more likely to appear on the tax return filed by a long-distance freight hauler than by a dentist), you are going to get a higher DIF score. Make sure the mortgage interest you deduct matches Form 1098 from the lender.

4)      Unusual or excessive deductions, particularly in relation to your income or your stated  So it is possible for just about any income or deduction item to affect your DIF score, depending

Beating the Computer

Managing your DIF score is the first defense against the IRS computer. So what can you do about your DIF score? Stay tuned for the next article

(Read Part 2 Here)

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