Why Did I Get Selected for An Audit?

By John Ellsworth, Esq January 5th, 2012

Why Did I Get Selected For Audit?

So, you’re the subject of an IRS tax audit and you want to know why. How did this tax audit happen? Well, here are some insights into the why and how of IRS tax audits. Please read on.

Selection of Returns for Examination.

After the initial review and correction process of tax returns has been completed, returns are classified for tax audit. Certain individual income tax returns with potentially unallowable items are forwarded to the examination divisions of the service centers for correction by correspondence tax audit. Otherwise, returns with the highest examination potential are sent to the examination divisions on the basis of workload capacities. Returns sent to the examination divisions may be examined by correspondence tax audit, in office tax audit, or in field tax audits generally conducted by IRS agents.

A taxpayer’s chance of being audited is not affected by either the date the return was filed or whether the taxpayer had called the IRS tax line.

Discriminant Function (DIF) System

The IRS uses computers to identify returns that warrant tax audit under what it calls the Discriminant Function (DIF) System. Under this system, each return is scored by means of mathematical formulas. The IRS has found that the tax audit potential of a return increases with the DIF score. An engineer friend of mine called upon 500 clients to submit their tax audit returns to him so that he could try to discover how the DIF score worked in their tax audit cases. He not only discovered how it worked, he also made this information available. It is an interesting and mathematically challenging study.

The IRS formerly employed the Taxpayer Compliance Measurement Program (TCMP), which was a random tax audit selection system developed by the agency to measure and evaluate taxpayer compliance characteristics. Information and figures obtained from the TCMP were used to determine the DIF. However, the TCMP has not been used by the IRS since 1987, and it has now been replaced by the National Research Program (NRP).

National Research Program (NRP)

The NRP is a tax audit study designed to accurately measure tax compliance while minimizing the need to contact taxpayers during the process. It is intended to be less intrusive, and to reduce tax audits of taxpayers who filed an accurate return. Moreover, it is designed to more effectively detect tax cheating than prior systems. While the IRS conducts over 700,000 regular tax audits annually, the NRP will extract data from a stratified sample of about 50,000 regular tax audits.

The NRP focuses on measuring three critical areas of tax administration: filing compliance, payment compliance, and reporting compliance. The first area to be addressed will be reporting compliance, to be followed by the other two areas.

Instead of the former practice of engaging in a “line-by-line” tax audit, the IRS will seek to reduce the intrusiveness of the tax audit by using more information that it has already collected. Those selected for tax audit under the NRP will be asked questions about only a limited portion of their tax returns. Some taxpayers will not be contacted at all, while others will participate by mail.

The number of face-to-face tax audits under the NRP will be reduced to a far smaller number than under previous studies. Moreover, this portion of an NRP tax audit will be comparable to a regular IRS tax audit, whereas under earlier programs, the examination usually took twice as long as a regular tax audit.

The NRP is expected to produce a number of changes, including redesigned forms, improved communications, suggested tax law changes, and enforcement focused on non-compliant taxpayers.

Starting in September 2002, the NRP began working on fewer than 50,000 IRS audits out of 132 million individual returns filed. There are four categories of IRS audits included in this, ranging from no contact with the taxpayer to a scaled-back tax audit that requires less taxpayer substantiation than previous studies.

The IRS intends to expand the NRP to cover corporate income tax, as well as employment and excise taxes.

Comment:

Analysts note that the IRS continues to explore new and improved means of ensuring compliance among taxpayers. An IRS Research Conference is held annually, with papers and slides being available on the IRS website. Some proposals include increasingly complex and detailed statistical models designed to improve the accuracy and completeness of the data obtained from the NRP and other such programs. One study notes that most current studies start with an estimation sample from which returns to be audited are selected; the problem is that the sample group selected for IRS audit will generally have a higher rate of noncompliance than the general population. For example, the IRS will compile a list of taxpayers to be audited, but will then elect not to tax audit those returns which are supported by receipts, while concentrating on auditing those returns without attached receipts. This distortion thus causes the noncompliance rate among the group of tax audit returns to exceed that which would be found if all the returns in a truly random group were to be audited.

Other grounds for selection of return

In addition to the programs discussed above (DIF and NRP), there are a number of specific circumstances which may increase the probability of a return being selected for examination. A return may be selected for examination based on information received from third-party documentation, such as Forms 1099 and W-2, that does not match the information reported on the return. A return may also be selected in order to address both the questionable treatment of an item and to study the behavior of similar taxpayers (a market segment) in handling a particular tax issue.

A return may be selected due to information received from other sources on potential noncompliance with the tax laws or inaccurate filing. This information can come from various sources, including the media, public records, or informants (did someone say ex-spouse?) The information is evaluated for reliability and accuracy before it is used as the basis of an tax audit, examination or investigation.

Please call us at your earliest opportunity if you would like more information about how this development affects you.

This entry was posted on Thursday, January 5th, 2012 at 6:31 pm and is filed under tax audits. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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