Audit Triggers

   
Discriminant Function System (DIF)

When a tax return is processed, the information on the return is compared to a precompiled set of averages for taxpayers in a particular class...what they earn and deduct. Then the return is assigned a DIF score. Variations from the averages of particular items on a return are weighted.

In the past, these averages were obtained from the Taxpayer Compliance Measurement Program (TCMP). A TCMP audit was the most feared of all audits because the IRS auditor was required to examine every single item on a return, including ages and marriages. However, the TCMP has been temporarily put on hold.

It is difficult to predict whether a return will be audited because a lightly weighted item could vary significantly and not cause the return to be selected whereas a heavily weighted item might vary only slightly and thereby cause the return to be selected. It is estimated that approximately 10% of all individual returns have audit potential.

The determination of DIF score is a highly guarded secret. Very few IRS employees know it’s workings. However, from experience with so-called "audit triggers", there is a certain degree of predictability as to whether a particular return is "susceptible" to audit.

Once a return with audit potential has been identified, it is sent to the Examination Division of a particular service center, such as Andover, Massachusetts. Selected reviewers manually look at the return and select approximately 10% of the 10-11% sample for audit. This is approximately 1 to 1.6% of all individual returns filed or approximately 2 million returns. These are divided into two categories: correspondence audits and field audits. 

Targeted Programs

Targeted program audits make up roughly 25% of returns actually audited. It is not known how many are selected to be sent down to reviewers. A targeted program is the audit of selected occupations that past experience has revealed a pattern of noncompliance. Such occupations have included waiters and waitresses, bartenders, attorneys, accountants, medical professionals, gas stations, jewelers, barbers and hair salons, automobile dealers, and check-cashing businesses. Almost any business or occupation in the following categories is subject to selection under a targeted program:

Cash-intensive businesses

Self-employed sole proprietors, independent contractors and the like

Taxpayers who claim home offices

Nonfilers

  
Document Matching Programs

The IRS receives millions of W-2s, 1099s, 1098s, and K-1s from employers, financial institutions, flow-through entities (S corporations, partnerships, limited liability companies, estates, and trusts), etc. The IRS then matches these against individual returns. When mismatches are found in favor of IRS, they issue a CP2000 letter, which is essentially a bill with the option to challenge it due to inaccuracy. Most of the "auditing" activity is done by correspondence, and is usually confined to the mismatched items, usually items of income.

Audit Triggers

The top audit triggers under DIF scores and targeted programs are as follows:

1040 business returns (Schedule C) with gross receipts of $100,000 or more

1040 business returns of certain occupations

Attorneys, doctors, dentists, and other professionals

Cash businesses known for skimming

1040 business returns with substantial losses or 1040 business returns with a low percentage of net income to gross receipts

1040 business returns for proprietors who sell products and show a significantly lower than normal gross profit

Multiple rental properties, especially those with substantial losses

Returns with significant deductions

Tax shelter activity

Automobile expenses

Travel and entertainment expenses

Returns with significant home office deductions

Too high percentage of space for home office

Significant dollar deduction

Deduction which causes a loss of Schedule C

Depreciation of fair market value of home

Returns with significant losses

"Hobby" losses

Casualty losses

Returns whose itemized deductions exceed the averages such as

Medical deductions

Tax deductions

Contribution deductions

Miscellaneous deductions

Returns prepared by tax return preparers on the IRSs Problem Preparers List

Returns that have been audited in the past

Failure to report income (or correct amount of income) reported to IRS on a Form 1099, a W-2 or Form K-1

Salaries and wages

Dividends and interest

Sale of a residence

Sales of securities

Sale of a rental property

Partnership, S corporation, trust or estate