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How IRS decides which tax returns are audited

This is common question. Recently the IRS was discovered to have illegally “targeted” certain politically conservative groups that were applying for tax-exempt status. If a political group had a “conservative sounding” name or theme, it received greater scrutiny. This placed a lot of heat on the IRS and the Obama administration, as they had to explain this to the American people why there was unequal treatment. Ultimately, it resulted in the resignation of Acting Commissioner of the IRS, Steven T. Miller. This has been called the “2013 IRS Scandal.”

But the question many have asked as a result of this scandal is “How does the IRS select a tax return for audit?” The IRS addressed this question in a 2006 Fact Sheet.

That IRS document explains that returns are selected using a variety of methods:

(1) “Potential participants in abusive tax avoidance transactions.” In other words, some taxpayer’s returns are selected because the IRS receives information when it audits others who are engaged in abusive tax avoidance transactions. The practical lesson of this is to be weary of engaging in business transactions with those who engage in, or promote, these sorts of abusive tax avoidance schemes.

(2) “Computer Scoring.” Some tax returns are selected because the IRS’s software selects it. Each tax return receives a “score” according to the Service’s past experience with similar returns. Specifically, the IRS’s “discriminate function system” rates each return for a potential in income change, and its “unreported income function” rates a return for the potential of unreported income. The IRS then selects for an audit those returns with the highest of these numbers.

(3) “Large Corporations.” The IRS often examines large corporate returns every year. A detailed discussion of these audits can be found here.

(4) “Information Matching.” The IRS will often “coordinate” one’s tax return with corresponding returns and documents and look for discrepancies. If one is found, the matter may be selected for audit. For example, a taxpayer’s return may be audited after the IRS notices that one’s reported income does not match his employer’s Form W-2 or his bank’s Form 1099 for interest statements.

(5) “Related Examinations.” Somewhat related to the first audit selection method above, some tax returns are selected for audit simply because they had transactions or business with someone else who was audited. This is the case of the IRS following the “bread crumbs” of a transaction.

(6) “Other Methods.&rd quo; Finally, the IRS identifies returns to examine when they are part of a “local compliance project.” For example, sometimes the IRS will select certain tax return preparers to audit and will examine those preparers’ clients. Sometimes also it will target certain sectors or sub sectors of a particular market.