Laurence Lawler: Hi! I am Laurence Lawler, National Director of the American Society of Tax Problem Solvers. This series is on how to prepare for an IRS Audit. We will be covering what prompts the IRS to audit a taxpayer in this session.
Obviously, knowing how the IRS selects tax returns for audit is a good step in knowing how to avoid an audit or how to be prepared for one if it comes up. Knowing the items that they look at in determining who should be audited is what we are going to cover now.
One of the main ways that the IRS selects tax returns for audit is the random selection process actually done by the computer. There is a well-guarded formula. It's called the DIF score, it stands for Discriminate Function. That is probably as well-guarded a secret in the government as the keys to the nuclear weapons are. No one knows exactly how it is. We just have some good indications as to what it is that causes a return to be selected.
Other things that cause a return to be audited are informants. Someone calling the IRS and telling them that the taxpayer perhaps is not filing correctly or not reporting all of their income, something of that nature.
A third way might have to do with prior audits where the taxpayer has been audited in the past, they've found problems, and they come back to look and see that the taxpayer has then corrected those problems on future years.
A fourth method might be deductions and losses that are compared to the income of the taxpayer. So if they deduct things that seemed too high relative to the amount of income that they have, then the IRS will flag those items and look into them and ask the taxpayer to document them. Some of the items in that area include meals and entertainment, travel and auto expenses. They are very common ones. If they have large or continuous losses from a business, they certainly would look into that. Another item might be large charitable or other itemized deductions that appear in the taxpayer's return.
If the IRS' computer gets information from third-party such as your employer's filing W2 forms or something filing a 1099 saying that they paid you, and that doesn't show up on your tax return, the IRS does match the information on your tax return to those third-party reports. If they don't match, that could result in an audit.
One of the other things that is a very high profile item in getting your tax return audited is if you file a Schedule C on the tax return. That's the schedule that reports income from a trade or profession. The IRS' determine that that is where they have a great deal of success in getting extra tax from taxpayers. They are convinced that Schedule C filers do not properly report and that auditing those returns is very, very fruitful.
Many of the Schedule C businesses are cash businesses, meaning that their sales are often done in cash rather than by credit card or check, and they find these to be very high profile businesses. So if you are running a cash business, and you are reporting on a Schedule C, you are a very high profiled return for audit. The IRS finds that those generate more money in additional tax than any other tax return that is filed with the government.
From here we are going to move on to when and how to prepare for the IRS Audit that you have coming up.