Generally, there are two main reasons why a taxpayer is selected for an IRS audit or criminal tax investigation:
Taxpayer Characteristics
Certain traits—such as very high income, cash-intensive small business operations, significant charitable contributions, or offshore accounts— exponentially raise the odds of an audit / criminal tax investigation, either because the IRS sees a higher risk of fraud or because it aims to maximize its “return on investment” by focusing on filers with potentially higher unreported tax liabilities.
Red Flags in the Return
The IRS’s Discriminant Function (DIF) system flags returns that deviate from statistical norms when compared to similar returns, identifying discrepancies in reported income, deductions, or credit claims. If your return scores high under DIF or its counterpart (UIDIF for unreported income), it undergoes further scrutiny—often culminating in a manual review to determine if an audit or criminal tax investigation is warranted.
Although random selection, informant tips, and open records can also initiate audits, a deeper understanding of red flags—individual or small business—can help you reduce your exposure to an IRS inquiry. If you’ve been selected for a tax audit, disagree with its outcome, fear potential tax evasion charges related to an upcoming or ongoing audit or ongoing criminal tax investigation, contact our dual-licensed tax attorney & CPAs immediately to schedule a reduced-rate initial consultation. Reach out to the Tax Law Offices of David W. Klasing online or call us today at (888) 564-1409.
How the Discriminant Function (DIF) System Works
Multiple Computer Systems, One Main Objective
The IRS relies on three computer systems to detect possible inaccuracies in returns. The centerpiece is the Discriminant Function (DIF), which uses statistical modeling to assign a numeric score to each return. A higher DIF score signals a greater possibility of underreporting, omissions, or errors. Two related systems—the UIDIF (Unreported Income DIF) and other specialized programs—further refine this analysis by comparing reported income to third-party data (W-2s, 1099s, 1098s) and perceived lifestyle factors.
Key Points:
- UIDIF zeroes in on potential hidden income by evaluating expenses, living standards, and other financial clues.
- Once flagged by DIF or UIDIF, a return typically undergoes manual review before the IRS decides whether to audit.
Statistical Analysis and Manual Review
After a high DIF score, an IRS examiner scrutinizes the flagged return. If that examiner sees strong evidence of errors or fraud, they’ll likely open an audit. If all appears consistent, the return might pass without further action. The tax lawyers of the Tax Law Offices of David W. Klasing can help guide you through an audit. If you are concerned that you have already made an error in handling your audit, we may be able to seek relief or take other corrective action to secure a pass on criminal tax prosecution even where you have a history of intentionally cheating trough a voluntary disclosure if you are not currently under audit or criminal tax investigation. To schedule a confidential tax consultation, call 888-640-3408 today.
Common Characteristics That Raise Audit / Criminal Tax Investigation Risk
High Earners
Taxpayers reporting incomes above $100,000 face a significantly higher audit / investigation rate than the general population. In 2023, filers earning $10 million+ endured an 11.0% audit rate; those in the $5 million–$10 million bracket experienced 3.1%, while middle-income filers (e.g., $25,000–$50,000) saw rates around 0.3%.
The IRS has dramatically increased its audits and investigations of high-income taxpayers in the last decade and even introduced a team of tax collectors explicitly aimed at targeting fraud and underpayment of taxes by the wealthy. While their official name is the “Global High-Wealth Industry Group,” they are informally known by those in the tax industry as the “Wealth Squad.” At the Tax Law Offices of David W. Klasing, our experienced dual-licensed tax lawyers & CPAs have extensive expertise in handling audits for high-net-worth individuals. We can guide you through a potential audit or criminal tax investigation by this IRS group—or any other IRS division—should the need arise.
Cash-Intensive or Unusual Small Businesses
Businesses primarily dealing in cash—such as restaurants, bars, or salons—invite added scrutiny. Significant or persistent losses on Schedule C can also prompt the IRS to suspect underreported revenue or improper write-offs.
Offshore Assets and Foreign Returns
With laws like FATCA and stepped-up Department of Justice enforcement, the IRS pays close attention to foreign accounts or filers who maintain overseas income generating assets. Missing or inaccurate FBARs (FinCEN Form 114) and foreign information returns (Forms 5471, 8865) often raise your DIF score.
Zero Income or Non-Filers
Failing to file or claiming zero income stands out. If the IRS receives data (e.g., 1099s) indicating you earned wages or interest, the mismatch may lead to an immediate red flag.
Increasingly, the IRS is exploring artificial intelligence to automate certain aspects of tax enforcement. Like the DIF system, AI-based tools rely on statistical models to flag anomalous returns. However, privacy, possible bias, and transparency issues arise if taxpayers are audited simply for deviating from standardized norms. According to the IRS’s current Strategic Operating Plan, expanded AI-assisted enforcement is on the horizon for large partnerships, large corporations, and their related employment tax returns.
Red Flags for Individual Tax Returns
Below are the most common individual tax return red flags that can inflate your DIF score:
Rounded Numbers
Perfectly even figures—like $5,000 in charitable donations—suggest estimates. Multiple rounded entries often pique IRS curiosity.
Unreported Income
The IRS matches third-party reports (i.e. 1099’s & W2’s) to your return. Omitting wages from an employer, investment income from a brokerage, or bank is among the quickest ways to trigger an audit, criminal tax investigation or CP 2000.
Sloppy or Incomplete Information
Simple math errors or partially filled forms cast doubt on your entire return. Tax software or professional assistance can help avoid these pitfalls.
Charitable Donations
Excessive contributions relative to your reported income can set off alarms. Meticulous records of large donations are crucial if questioned.
Earning Over $100k
As noted, higher-income filers are more susceptible to audits / investigations due to higher potential liabilities.
Low-Income Occupation
If your reported salary diverges significantly from IRS expectations for your profession and region, you might be flagged for possible underreporting.
Federal vs. State Return Inconsistencies
If you list different income totals at the federal and state levels, both agencies may become suspicious and coordinate audits.
Large Swings in Income
A stark jump or drop in earnings without an apparent cause invites IRS scrutiny.
Job Expenses for W-2 Employees
Unreimbursed employee expenses are rarely permissible unless you satisfy strict requirements. Claims in this category often lead to audits.
Tax Avoidance Transactions
If the IRS acquires records from alleged “tax-avoidance” promoters and identifies your name, you could be singled out.
Red Flags for Small Business / Self-Employed Returns
Likewise, self-employed taxpayers and small businesses face distinct concerns:
Home Office Deductions
While legitimate home office write-offs exist, the IRS has found many abuses. Document exclusive business use and maintain a solid backup.
Filing a Schedule C
Studies show Schedule C filers draw more audits. Think about forming an LLC or S Corp to separate business deductions and possibly lower red-flag triggers. Lastly, a fraudulent schedule C loss offsetting W2 income is the most common criminal tax fraud pattern known to the federal and state taxing authorities.
Entertainment Deductions
Extensive or vague travel, meals, and entertainment costs often draw IRS attention. Detailed logs (time, place, business purpose) are essential.
Hobby vs. Business Losses
The tax code disallows deductions for hobbies. If your “business” consistently shows losses, the IRS may classify it as a hobby unless you can prove a profit motive. This will limit your write-offs to only the reported income from the activity.
Low Income with Large Deductions
Excessively high write-offs relative to business income can raise suspicion, especially if repeated year after year.
Claiming a Net Loss
Chronic net losses cause the IRS to suspect inflated or fabricated deductions.
The IRS aggregates all red flags—income, deductions, credits, foreign accounts—into a DIF score. A single moderate anomaly won’t necessarily lead to an audit / investigation, but multiple factors can spike your score. When that happens, an IRS examiner evaluates the return to decide if further steps are warranted. While three-quarters of audits start with DIF selection (kicking off with the highest scores), the remaining quarter arises from third-party data (Forms 1099, W-2, 1098), open-record searches, or informant leads. The IRS often compares your reported income with perceived lifestyle indicators obtained via AI—vehicles, real estate, etc.—to uncover possible underreporting.
If you have a suspicion that your audit was triggered by a mistake or some potential wrongdoing on your part, the most important thing you can do is to seek the representation of an experienced dual-licensed tax attorney & CPA as soon as possible. This is essential because if you believe that you made an accidental or intentional error, a chance exists that the agent may interpret the surrounding facts and circumstances as wilful tax fraud or tax evasion.
To date our firm has never had an audit client that we represented to be charged or criminally prosecuted.
Contact The Tax Law Offices of David W. Klasing If You Are Worried About a High-Risk IRS Tax Audit / Criminal Tax Investigation
At the Tax Law Offices of David W. Klasing, our dual-licensed Civil and Criminal Tax Defense Attorneys & CPAs integrate deep tax-law knowledge with decades of accounting and audit / criminal investigation experience to defend your interests. We carefully assess your filings—whether concerning your income, deductions, offshore holdings, or business structures—for any red flags that might spike your DIF or AI-driven score. By methodically reviewing and reinforcing your recordkeeping, we ensure you have the proof needed to respond confidently if the IRS questions or Criminal Investigation targets your returns.
