It goes without saying that the IRS will likely not audit each and every tax return, and yet every tax return is fair game. That said, while the IRS might only audit a small percentage of filed returns, the chances are great that they will opt to audit only those returns that get flagged. This is done for them by a computer system called the Discriminant Information Function (DIF).
The DIF automates the process and yet also has the capacity to scan all tax returns received by the IRS. Whatever income bracket you belong to, your return will be run through the DIF. The DIF, in turn, flags certain tax returns with certain pre-identified anomalies that show the potential for the probability of evasion or error. Those returns are then sent to the IRS National Computer Center, where they are scored for the probability of misstatement when compared to the returns of other taxpayers who earn approximately the same income. The higher the probability, the greater the likelihood that the said tax return will be chosen for audit.
Some of the red flags that will boost your rank as someone the IRS will pay close attention to include not reporting all of your income, reporting unusually large business expenses, reporting several years of business losses, and even making large charitable contributions. If it stands out as “different,” the greater the chances that the DIF will identify the return and mark it for assessment.
Businesses in certain categories also face a higher chance of being audited. Some businesses belong to a category at a higher risk of tax non-compliance. For instance, cash-based businesses such as liquor stores are frequent targets of IRS and CDTFA sales tax audits. Likewise, cannabis businesses rely upon cash transactions, and the IRS and California tax agencies are naturally suspicious of businesses that operate in cash.
Types of Audit
While IRS audits have a reputation for instilling fear in taxpayers, not all audits are made to be feared. There are two general categories of audits: the correspondence audit and the in-person audit.
- Correspondence Audit. This is simply a letter or notice from the IRS where a taxpayer is asked to verify information or answer a few questions. If the taxpayer responds accordingly, the audit will be resolved.
- In-person Audit. This type of audit is conducted, as the name implies, in person. Again, the taxpayer is asked to verify information or answer a few questions.
- Office Audit. This type of audit is similar to the first two except that it is conducted in the IRS offices.
Typically, if a taxpayer answers the assessing officer’s questions satisfactorily, the matter is resolved.
Most experts recommend that you keep your records or paperwork dating back at least six years, just in case you get flagged for an audit. Typically, the statute of limitations for an IRS audit is three years after a return, but they can go back as far as six years for “substantial errors.” Keeping your records organized and on-hand will help you resolve those questions quickly and easily, if and when they do get raised. Of course, being careful and meticulous about your tax return in the first place is the first step to avoiding an IRS audit.
If, on the other hand, the taxpayer fails to answer the assessing officer’s inquiries satisfactorily, the assessment process begins, and the assessor gets to work determining the taxpayer’s liability.