How does the IRS choose who to audit?

March, 17 2020 by Carolyn Richardson, EA, MBA

Receiving a letter from the IRS informing you that your return was selected for audit may be one of the most frightening things you can get in the mail. You might be asking yourself “why me?” You might also know people who you think deserve to be audited a lot more than you and wonder why they weren’t being audited. Audits happen for multiple reasons and, while you may think that a disgruntled neighbor ratted you out to the IRS, the reality is that most IRS examinations are initiated for other reasons. Audits, with one exception, are not determined at random. The only returns that are selected on a totally random basis are those audited through the National Research Program. If your return was selected for audit because of this program, the initial letter to inform you that your return was selected for audit will tell you that. Otherwise, you can assume that there was something on the return (or possibly left out of it) that triggered the audit.

The majority of non-random audits are determined by the return’s “DIF” score. DIF stands for Discriminant Index Formula, and is a mathematical calculation the IRS runs on every return filed. Different items on the return are given different weighted numbers. The return is also compared against national averages and prior returns to determine the score of items on the return. The higher the resulting total score, the more likely you are to be audited. While it’s possible that the selected return has no issues, history has shown the IRS that these returns are likely to have errors or omissions that result in the underreporting of tax. For example, if your return suddenly has a drop in income or an increase in deductions, this will bump up the return’s score. Likewise, claiming deductions that do not seem to jive with other information in your return may jack up the score, such as reporting employee business expenses when there are no wages reported on the return.

Another common method the IRS uses is computer matching. This is normally done for income items such as wages, pensions, or stock sales which may be missing on the return. The IRS compares what is on the return with what is reported to them by third parties, such as your employer or IRA trustee. If there’s a discrepancy, the IRS will send a notice to you asking you to explain the discrepancy. This matching is also done for some deductions that have third party reporting requirements, such as for mortgage interest or student loan interest. This is a great time and money-saver from the IRS’ perspective, as the document match program allows the IRS to question a return without actually looking at it because the notices are generated by computers.

And of course, there’s also a possibility that your neighbor DID rat you out to the IRS. The IRS maintains an active whistleblower program that encourages people who may have information about tax cheats to come forward and report them. This can be done anonymously and, if the IRS does find an issue with the return, the informant may qualify for a cut of the tax collected.

Similarly, the IRS runs various “project” audits depending on the perceived degree of potential tax losses from other schemes and areas where taxpayers may not be complying with the law. If you are using a dicey preparer who promises you large refunds by inflating deductions, the IRS may eventually select that preparer – and all his clients – for review. Another area that the IRS is concerned is largely unreported is virtual currency transactions, such as with Bitcoin or Ethereum. The IRS was permitted to issue a “John Doe” summons to Coinbase to request information on their clients. If you ran a large number of virtual currency transactions through that exchange, you might get flagged for audit if you failed to report the transactions. Similarly, taxpayers with offshore accounts may also find themselves facing the IRS because of enforcement action taken by the IRS against foreign banks.

Regardless of WHY the IRS has selected your return for audit, facing an audit alone is a scary process for most taxpayers. You might want to seek professional assistance such as an Enrolled Agent or CPA. And of course, if you want that same kind of professional audit representation for a very reasonable cost, you should look into the services offered by TaxAudit.