Three quarters of all returns are selected for audit based upon the return’s computerized DIF score. A DIF score comes from the taxing authority’s often highly secretive computerized rating system, or DIscriminate Function (DIF). Each return undergoes statistical analysis designed to score the return as to its likelihood of material misstatement. A return can be understated because of under reported income or over reported deductions.
The program also identifies returns that do not report correctly information the taxing authority has obtained from third parties concerning your taxable income such as 1099′s, 1098′s and W2′s. The service starts the audit selection process by selecting for audit returns with the worst DIF scores which are 999′s and then proceeds to the 998′s, 997′s and so on until they run out of audit budget. It is this audit selection methodology that led to the expression common to the tax profession of; “Hogs get slaughtered but pigs get fat”.
The other quarter of returns are selected based on information obtained from outside sources that indicates that a return may be understated. These sources of information include newspapers, public records, and whistleblowers. Taxing authorities are known to compare an individual’s perceived standard of living gleamed from these sources of information up against their reported income to determine if a taxpayer’s life style makes economic senses given their reported income level.
Below is a list of factors that add to a taxpayer’s audit potential because of their perceived potential for abuse and the taxing authorities history of success in determining positive audit adjustments to taxable income in these areas:
Taxpayer has reported or omitted amounts that materially differ from information gathered by the taxing authorities from third parties on their return. (i.e. W2′s 1099′s 1098′s 1099R’s)
Taxpayer has complex and large dollar investment or business expenses on their tax return.
Taxpayer underwent a previous audit that resulted in a tax deficiency.
The taxpayer has complex tax transactions that lack sufficient explanation on their tax return.
Taxpayer has itemized deductions on their tax return that is disproportionate to their income or that are outside the taxing authorities parameters.
The taxpayer owns or works for a business that receives large amounts of cash in the ordinary course of business.
Taxpayer has claimed substantial cash contributions to charities that are disproportionate to their income.
Taxpayer is a shareholder or partner in a partnership or corporation that is currently under audit.
An informant or whistleblower has given information to the IRS (i.e. ex-spouse, or disgruntled business partner or employee).
Taxpayer has made extensive use of offshore credit cards, investment or bank accounts.
Taxpayer filed a high-income return.
Taxpayer is self employed and thus is considered by the taxing authorities to be more likely to under-report taxable income and overstate tax deductions. Additionally, self employed individuals that report Schedule C losses are often selected for audit.
Taxpayer’s engaged in employment tax schemes, such as employee leasing, paying in cash and or filing false payroll tax returns.
Taxpayer’s that unreported alimony. The IRS matches alimony deducted by one ex-spouse to the income reported by the other ex-spouse.
Non-filers. Each taxing authority has it own non-filer strategy to identify the most egregious non-filers. Most non-filers are discovered via computers that attempt to match the taxable income obtained from documents provided by third parties.
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