Did you know that the IRS audits your Form 1040 every year? Or, did you think that only 3% of all Form 1040s are audited as is often published? Which is it . . . 100% or less than 3%? To paraphrase Bill Clinton’s definition of “is”, it all depends what you mean by the word “audit”.
The fact is that every single return filed is audited by the IRS. If that is the case, why were you not notified of the audit? More about that later.
The IRS has a wealth of information about every taxpayer. The IRS has a program called the Information Returns Processing System (IRP). This program collects W-2 information from employers, 1099-INT from banks paying interest, 1099-DIV from payors of dividends, 1099-B statements from brokerage houses and financial advisors, 1099-MISC to report self-employment income, 1099-CODs, 1099-A, 1099-K, 1098 forms reporting interest expense and real estate taxes, and quite a few other forms. The IRS computers are checking the numbers on your return against the third-party information it has on you searching for discrepancies. The IRS wants to make sure that you are reporting all of your sources of income.
Did you know that the IRS also audits your tax deductions? How does the IRS do that if it does not receive any type of third party verification? The IRS conducts a very special National Research Program (NRP) examination on a select group of taxpayers. During this type of audit exam, the IRS requires the taxpayer to PROVE every item on the tax return filed. If you claim to be married, you must produce a marriage certificate. If you claim dependents, you must provide the auditor with their birth certificates. For every tax deduction, the IRS requires to see the detailed proof and support. Taxpayers who are on the receiving end of these audit exams find them to be very time consuming and comprehensive. Why does the IRS challenge every item on the tax returns selected? The IRS goal is to determine the percent of reported tax to the total true tax liability as computed by the IRS. The difference between the reported tax and the true tax is the basis to compute the tax gap. Using this audit technique, statistical sampling analysis, and information gathered from the Census Bureau population surveys, the IRS estimates the amount of unreported taxes. This tax gap is estimated to be $385 billion per year.
The IRS then uses the information from the NRP examinations and creates a Discriminate Inventory Function (DIF) system which helps the IRS to estimate the appropriate tax deductions for each taxpayer. Although the DIF scoring system is not publicly disclosed, one of the primary variables is likely is thought to be the ratio of your deductions to your income. The IRS also has a second computer program called the Unreported Income Discriminant Index Formula (UI DIF) which searches for tax returns that show high expenses and low income. For example, if you are claiming 12% of your annual income as charitable contributions and the DIF score shows that the percentage should be around 4%, the IRS will assign audit points to that return. If your return shows that you own a pizza shop and your report $200,000 of gross receipts, and the IRS receives information from credit card vendors that shows that you had $175,000 of credit card sales and industry studies show that the average pizza shop has 60% of its gross receipts in cash sales, additional audit points are assigned to your return.
While 100% of all tax returns are audited by the IRS, only those returns which have the highest DIF audit points receive the IRS correspondence requesting that you send supporting documents or that an agent will contact you to conduct an examination of your tax return (the less than 3% figure).
If you want to discuss your business or personal tax planning and tax preparation concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
