In order to determine how to respond to an IRS Tax Audit, it is helpful to understand how tax returns are selected for examination. The IRS selects returns for examinations in several ways, some based upon objective criteria coded into a carefully protected computer program and others based upon old fashioned investigation work.
Selection for an IRS Audit does not always suggest there’s a problem. The IRS uses several different methods:
- Random Selection and Computer Screening? Sometimes returns are selected based solely on a statistical formula. The IRS compares your tax return against “norms” for similar returns. The IRS develop these “norms” from audits of a statistically valid random sample of returns, as part of the National Research Program the IRS conducts. The IRS uses this program to update return selection information.
Many returns are selected through the use of a computer program called the Discriminant Function System (DIF). This program scores each return that is filed for potential error based upon past IRS audit experience. The returns receiving high scores are made available for examination. IRM 22.214.171.124 (10-24-06). The DIF formulas are listed in the Law Enforcement Manual, which is not publicly available.
- The Discriminate Function (DIF) score is the product of a mathematical formula for identifying and selecting returns for examination.
- The program scores tax returns using a formula based on historic information obtained from specific examination programs. A high DIF score indicates a high potential for adjustment.
- The Service periodically conducts compliance studies to update and reformulate its basis for audit selection formulas.
- Different types of taxpayers and returns are subject to different DIF formulas. While the specifics of the program are not public, certain items appear to cause a return to be selected for examination, such as:
i. Participation in a Tax Shelter,
ii. A large Charitable Contributions,
iii. A Home Office Deductions
iv. A Large Travel & Entertainment Expense (e.g. Sky Box. etc.) or
v. A Large Automobile Expense.
Returns selected under the DIF program are then manually screened, so that attachments to the return and other data that a computer cannot detect can be properly considered.
Other returns are selected at random under current national or regional studies, such as the National Research Program (NRP), the successor to the Taxpayer Compliance Measurement Program (TCMP). The results of these examinations are used to measure and evaluate taxpayer compliance and to revise the DIF program. NRP and TCMP audits.
Alternatively, the IRS may receive information from other federal agencies. (See IRM 4.6.2 (8-1-02)) and they may also receive information through federal-state programs (See IRM 126.96.36.199.4 (10-24-06)).
- Related examinations – The IRS may select your returns when they involve issues or transactions with other taxpayers, such as Business Partners or Investors, whose returns were selected for audit. This is affectionately referred to as an “Audit by Infection.”
- Review After Selection by IRS - After selection, an experienced auditor reviews the return. They may accept it; or if the auditor notes something questionable, they will identify the items noted and forward the return for assignment to an examining group.
a. Filing an amended return does not affect the selection process of the original return. However, amended returns also go through a screening process and the amended return may itself be selected for audit.
b. A refund is not necessarily a trigger for an audit, but it could trigger an examination.
4. Information Provided by 3rd Parties – The Service also relies on information provided by third parties, such as banks, brokers and employers. Much of this information is required to be reported by payers of certain types of income on Forms W-2 or 1099.
5. Referrals by IRS Agents -Referrals may also be made by other examining agents. For example, the return of a party related to another taxpayer being audited, such as the partners of a partnership being audited may also be selected for audit. The Service also may investigate tips regarding potential noncompliance, and select those returns for audit as a result.
6. Other IRS Audit Triggers - Examinations may also be triggered a variety of other ways, such as, by mathematical errors or missing information. Also, a claim for refund can potentially trigger an examination.
The IRS has broad authority to examine tax returns. An understanding of the rights and responsibilities of both taxpayers and the examining agent can help reduce the scope of a tax audit or examination and can lead to a more favorable disposition.