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Your tax return was selected for an income tax audit? IRS audits one tax return out of every hundred it receives. How could you be so lucky?

Selection of returns for examination

Internal Revenue examines a shockingly small percentage of tax returns filed. A few years ago the stated goal was to examine 5% of returns filed, to keep taxpayers honest. Then IRS’s reputation was tarnished by some overly aggressive individuals and techniques that caught Congress’s attention. Congress reduced the IRS budget, severely limiting the number of auditors (and therefore audits).

In the year 2008 (dealing with 2007 income tax returns), Internal Revenue Service claimed to examine 1% of tax returns. As shown in the table below, published by the Internal Revenue Service, all categories of tax returns showing income of less than $200,000 are actually audited on a less than 1% basis. Even people who have income above $10,000,000 per year face less than one chance in ten of a tax examination

Table 9b.  Examination Coverage: Individual Income Tax Returns Examined, by Size of Adjusted Gross Income, Fiscal Year 2008

Returns filed in Calendar Year
2007 (percent) [2]
Examination coverage in Fiscal Year 2008 (percent) [3]
Size of adjusted gross income [1]
All returns [4] 100.00 1.00
No adjusted gross income [5] 2.13 2.15
$1 under $25,000 40.51 0.90
$25,000 under $50,000 24.31 0.72
$50,000 under $75,000 13.44 0.69
$75,000 under $100,000 7.99 0.69
$100,000 under $200,000 8.69 0.98
$200,000 under $500,000 2.25 1.92
$500,000 under $1,000,000 0.43 2.98
$1,000,000 under $5,000,000 0.23 4.02
$5,000,000 under $10,000,000 0.02 6.47
$10,000,000 or more 0.01 9.77
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[1]  Adjusted gross income is total income, as defined by the Tax Code, less statutory adjustments—primarily business, investment, and certain other deductions.
[2]  In general, examination activity is associated with returns filed in the previous calendar year.
[3]  Represents the number of returns examined in Fiscal Year 2008 for each adjusted gross income (AGI) class, as a percentage of the total number of returns filed in Calendar Year 2007 for that AGI class.
[4]  In addition to examinations of returns filed, IRS examined more than 158,000 cases in which no return was filed.  These nonfiler cases were referred for examination by the Collections Program and the Automated Substitute for Return Program (ASFR).  In the ASFR Program, IRS uses information returns (such as Forms W-2 and 1099) to identify persons who failed to file a return and constructs tax returns for certain nonfilers based on that third-party information.  These nonfiler cases are excluded from the examination data in this table.
[5]  Includes returns with adjusted gross income (AGI) of less than zero.  AGI may be less than zero when a taxpayer reports losses or statutory adjustments exceed total income.
SOURCE: Research, Analysis, and Statistics, Office of Research  RAS:R

Selection of Tax Returns for Audit

The Internal Revenue Manual states, at 4.1.1.1-5.“The primary objective in selecting returns for examination is to promote the highest degree of voluntary compliance on the part of taxpayers.”

How would returns be selected to “promote the highest degree of voluntary compliance on the part of taxpayers”? Wouldn’t a random chance have the greatest effect of keeping people honest? That is not the way returns are selected for audit.

With so few returns being audited, IRS attempts to make every audit count. It wants to bring in as much revenue as possible from its audits.

The most common source of tax returns selected for audit is the comparison of income shown on the return with the reports the payers have sent to IRS. Since IRS knows what it believes to be your error, it  computes the increase in tax before you are even notified. These audits are usually handled by correspondence. You will not receive a letter that says “You have reported more income than we think you actually received,” as IRS’s computers are programmed to find underreporting on tax returns. (The computers couldn’t be programmed otherwise, unless all payers filed reports on all payments.) IRS records can be mistaken, and the information submitted to IRS can be erroneous. If you are notified that your tax return does not agree with records submitted to IRS, take the notice seriously, and check all the income IRS thinks you received.

A second common way in which tax returns are selected for audit is by computer scores calculated for the return based on the information shown on the return. IRS has a program called the Discriminant Inventory Function System (DIF) which assigns a numerical score to every tax return based on the items shown on return and on previous returns for the same taxpayer. The DIF score is calculated to select returns where there might be errors or underreporting resulting in relatively large recoveries of tax. A self-employed person in a business that handles a lot of cash transactions, whose business does not show the sales IRS would expect, based on the expenses shown on the return, would make a good audit candidate. If the person consistently earns a small amount, but lives in an exclusive neighborhood, that might add to the DIF score. IRS does not disclose either how DIF scores are calculated, or the DIF scores of returns selected for audit.

IRS also selects returns for audit based on information it collects from public records, newspapers and tips from individuals. Big Brother is watching; don’t brag about your tax exploits.

IRS selects some returns for audit randomly, hoping to keep all of us honest. With a total of only 1% of tax returns audited, and large numbers accounted for by discrepancies with information submitted by third parties, and by DIF scores, there is room for very few random audits.

How to avoid an audit

Avoid an audit by fitting into the pack. If you have unusually large amounts of itemized deductions your chances of an audit are increased.  Averages are published by IRS. Complex transactions, especially transactions that are designed to take advantage of tax loopholes increase your chances of being called in.. A self-employed person in a business that takes in a large amount of cash is more likely to be audited than a wage earner. Do you claim a large amount of charitable contributions? Have you bragged to others about a “clever” tax strategy? Claim all your legitimate deductions, but be aware that some deductions make an audit more likely.

You are entitled to bring someone with you to assist you at a tax audit. The people you may bring are the persons authorized to represent taxpayers before the Internal Revenue Service—attorneys, Certified Public Accountants, enrolled agents (usually former IRS employees who have passed an exam), and the person who prepared your return.

The Internal Revenue Code specifies that discussions between taxpayers and their professional advisors, attorneys, accountants or enrolled agents, are “confidential”. Confidentiality of conversations with attorneys is a tradition of long-standing, but confidentiality of communications with accountants is a new concept. How confidential are your communications with your accountant? The Internal Revenue Code provides that communications with your attorney, accountant or enrolled agent are protected as long as IRS is working on civil matters (How much tax is due?), but may have to be disclosed in criminal investigations.

Why are you Nervous?

What are the chances that you are going to end up owing IRS after your audit is complete? Look at the sources of how your return was selected for audit. Nearly all of the sources indicate that IRS has already determined that it is likely that you owe money: Comparison of your return with reports from payers of income; a DIF score that indicates that your return would likely yield additional tax; tips from individuals or public records that seem to contradict your declared income. A few returns are added at random, but generally you can expect that IRS has selected you because it sees some issues or feels it will find some issues that it would have a pretty good chance of winning, if they argued against you in court. You are likely to pay some money before this is over.

Another reason you should be nervous is that the IRS employee you are dealing with has been told to challenge you on every issue that the government might win on, if the issue were taken to court. Examination level employees are not permitted to view your audit as a judge; their job is to spot the issues for higher-ups to settle or to argue in court. Examination level employees are the District Attorneys of the tax system. Their job is to raise the issues—someone else will decide them.

The fact that examination level employees raise all issues on which the IRS has a chance of winning is not a bad thing, it is just a fact of life. If you want “justice”, you will have to appeal the audit up to a level where employees can take into account the chances of IRS winning an issue, and settling with you on that basis.

The unfortunate part of raising all issues that favor the government is that, after the auditor has raised every issue the government might win, including strong issues, where IRS’s chance might be 80 or 90%, and including weak issues where IRS’s chances might be 25 or 30%, the auditor is instructed to try to get your agreement to his one-sided report. Is the auditor a judge, trying to dispense impartial justice? Absolutely not, but he tells you that he is just applying the law.

Prepare, Prepare, Prepare

If your return is selected for audit, prepare for the audit. It’s very easy to treat the letter from IRS as simply a notice of an appointment. Don’t do it. IRS tells you in its initial contact with you the areas it wishes to question. Take some time to try to reconstruct the figures shown in those areas. It has been months or possibly a couple of years since you completed work on the tax return being questioned. You’ve put your papers away, and it will take some time to recall the various sources of figures on the return. Put in the work. Your efforts will be justified. When you explain an item to the auditor, you will be much more convincing if you clearly recall how you arrived at the figure originally.

If you have been audited on the same issues in the past two years with no changes, IRS will generally waive your audit.

The audit itself is conducted informally. If it is a correspondence audit, you can gather and send any supporting documents you think would be helpful—receipts, invoices, letters you ask others to write to support your position. Send as complete an explanation as possible along with the documents. If your audit is in person, prepare the same kinds of things to bring to the audit, and you will have the added benefit of being able to talk to the auditor and explain the relevance of the documentation.

If IRS disbelieves one or more deductions on the return, it is likely to disallow the deduction. If it disbelieves income figures on the return, it may contact third parties to get information to reconstruct your income. Before IRS contacts third parties about your tax return, it is supposed to notify you of its plans to do so.

You are allowed to raise issues in your favor at the audit. If you forgot to deduct sales tax on a new car, bring it up. If you missed aa contribution to the Haiti earthquake victims, bring your proof. The auditor is directed to accept any new issues from the taxpayer whenever you bring them up.

Conclusion of the Audit

At the conclusion of the audit, the result will be either a “No Change” determination by the auditor, or suggested changes by the auditor. The suggested changes are usually in the government’s favor, for the reasons stated above: first, your return was selected because of the likelihood that there were errors in your favor, which the auditor has now uncovered, and second, the auditor is instructed to work for the government, raising its issues, not yours. The changes are reported to the taxpayer on a Statutory Notice of Deficiency (a 30 day letter). You can either agree with the auditor’s changes, or you can disagree. If you agree, you can sign your agreement on the Notice of Deficiency, and make arrangements to pay the additional tax.

If you don’t agree with the results of the tax audit, there are several steps that you can take to try to get a more favorable result. First, you can ask for a conference with the auditor’s manager. The manager’s job, like the auditor’s, is to raise every issue on which Internal Revenue Service might win at trial. Neither the auditor nor the supervisor is supposed to be “fair” with the taxpayer; they are not supposed to be impartial judges. Examiners are to be the “prosecuting attorneys.” The manager is working under the same rules the auditor works under, but you do get a second look by a more experienced auditor. The manager may have more pressures to settle cases, and may offer to drop an issue if you can accept the remainder of the audit.

This “Manager’s Conference” is easier to arrange and more productive after an in-person audit than after a correspondence audit. After an in-person audit you can usually arrange a face to face meeting with the auditor’s manager. After a correspondence audit you can generally only talk to the manager on the phone, a much less satisfying arrangement. Regardless of how the Manager’s Conference will be conducted, prepare for it. Prepare for the individual issues that the auditor has raised. Get additional documentation. Dig out more records. Get letters confirming your position from your employer or your doctor. This is your second chance to win arguments at the audit level—take advantage of it.

The auditor’s job and his supervisor’s, is to raise every issue on which Internal Revenue Service might win at trial. Neither the auditor nor the supervisor is supposed to be “fair” with the taxpayer; they are not supposed to be impartial judges. Examiners are to be the “prosecuting attorneys.” But, of course, both the auditor and the supervisor wish to close as many cases as possible, making as few waves as possible. They will try to concede a little in order to resolve a minor issue, or occasionally they will trade issues, withdrawing one where IRS’s case is weak if the taxpayer agrees to accept an issue where IRS’s argument is stronger.

You may resolve one or more issues in the Manager’s Conference, but still have more issues which were not resolved. Don’t despair. Even after the Supervisor’s Conference about 19 out of 20 cases are resolved before reaching any court.

Beyond the Manager’s Conference, you can appeal the auditor’s findings to the only audit level within the IRS, the Appeals Division. See the topic “Appeal Your Tax Audit”. The Appeals Division’s job is to reduce the number of unagreed cases. Move to Appeals, and you will get several chances to improve the findings of the audit.

References:

Internal Revenue Code:

Section 7123, Appeals dispute resolution procedure

Treasury Regulations:

Section 601.105, Examination of Returns and Claims for Refund, Credit or Abatement

Internal Revenue Manual:

Part 4, Examining Process

Internal Revenue Publications:

No. 556, Examination of Returns, Appeal Rights and Claims for Refund