If you have low tolerance for stress, keep the IRS away at all costs. IRS audits can be costly, lengthy and physically and emotionally draining . These are the topics covered in this section:

  • The story of Allen Smith
  • Audit Selection
  • Why Me?
  • Are You Claiming More Deductions Than the Norm?
  • Income and Audit 
  • The Audit Burden

The Story of Allen Smith

Allen is a recent tax client of mine. Allen admits he has zero tolerance for stress. None. So, Alen maintains immaculate records to keep the IRS away. He has been in business for 32 years and has never gotten audited. Allen is so confident in his record keeping that he puts every year inside the envelope with his tax return a sticky note that says: “Please Audit Me!”

Allen almost got his wish last year when he received in the mail a letter from the IRS telling him that taunting the federal government is not a wise thing to do, but no audit!

The reason Allen never gets audited, even though he taunts the IRS every year, is because he does not do ANY of what you are about to read. 

Let's start first with how a tax return gets selected for an audit.

Audit Selection

The IRS computer is to blame for most audits. Each year, your tax return data is sent to the IRS National Computer Center where it is analyzed by a computer program called the Discriminant Function. Your tax return is given a numerical DIF score—the higher the score, the more audit potential the return has.

The DIF program is super secret—few people even in the IRS know how it works or why a return is given a particular score. Outsiders guess that hundreds of variables on a return are weighed by the IRS computer. One known variable is called “total positive income,” which means everything you took in from your services and investments, before any deductions or exemptions. If this number is over $100,000, your chances of an audit double (roughly). If you earn more than $1 million, your audit rate is nearly 10%. The key variable is believed to be the percentage of deductions and number of exemptions claimed.

The IRS has a second computer scoring program to catch people not reporting all of their income. This is a slightly different approach from the DIF program, which relies heavily on deductions and exemptions claimed. This program is called the Unreported Income Discriminate Information Function (UIDIF). It scores individuals based on a high-expense/low-income ratio. In plain English, the tax man is looking for folks who look like they are living beyond their means. 

For instance, you and your spouse report income from your jobs of $40,000 and you claim mortgage interest and real estate taxes of $35,000. Even assuming that you didn’t owe any taxes that year, it would be tough to live on $5,000—so the IRS believes. Of course some people have down income years and simply borrow or dip into savings to get by. These explanations can always be made to an auditor, if necessary.

One in ten tax returns—those with the highest computer scores—are initially selected for further review. IRS classifiers (human beings) then look at this batch and recommend approximately 10% for audit.

The final say-so on who gets audited face-to-face is made at local IRS offices by examination group managers. These people supervise and assign the auditors, often according to their experience and expertise. Managers decide whether you will be audited at the IRS office or will get the more rigorous field audit.

IRS field offices have their own audit-screening selection process which takes into account income and expense levels in their communities—for instance, people are more likely to claim car expenses for business in Los Angeles than Manhattan. Group managers select less than 10% of the returns received from the IRS classifiers—the 10% of all tax returns—to be audited. Historically, the net result is that only about ¾ of 1% of all returns are actually audited.

Why me, not Allen Smith?

According to the IRS Manual, only significant items should be examined. What is considered significant depends on the IRS’s overall view of the return as well as particular items that seem questionable. Factors that are likely to figure into the audit selection process include things that Allen does not do:

  • Comparative size of an item to the rest of the return- A $5,000 expense on a tax return reporting $25,000 in income would be significant; the same expense on a $100,000 income return wouldn’t be.
  • An item on the return is out of character for the taxpayer- A plumber claiming expenses relating to a business airplane would cause suspicion.
  • An item is reported at an inappropriate place on the return- For example, $2,000 of credit card interest reported as a business expense. The IRS might suspect that you improperly deducted personal interest as a business expense.
  • Evidence of intent to mislead on the return- Filing a tax return with missing schedules or not providing all information asked for on the forms raises an IRS classifier’s eyebrows.
  • Your gross income- The IRS scrutinizes higher earners. If you make over $100,000 per year, your audit likelihood is one in 20 versus one in 100 for the general population.
  • Self-employment income- The IRS is most suspicious of people in business for themselves. Sole proprietors are four times more likely to be audited than a wage earner.
  • Losses from businesses and investments claimed on the tax return- If your business and investments show losses on your tax return, the IRS may want to know how you paid your bills. Most likely to be audited are taxpayers reporting a small business loss.
  • Sloppiness and round numbers- A messy return, especially if handwritten, attracts a classifier’s attention. He may think you don’t take your tax-reporting responsibilities very seriously. Use of round numbers—for example, $5,000 for business advertising, $2,000 for transportation and $1,500 for insurance—is a dead giveaway that you are estimating, not reporting from records.

Are You Claiming More Deductions Than the Norm?

One of the chief components of the IRS DIF scoring system is how close your tax return is to the norm of others with similar deductions. According to author Amir Aczel ( Four Walls Eight Windows Press), the IRS is most likely to audit you if your return shows a high ratio of deductions to income on three schedules:

  1. Schedule A, Itemized Deductions
  2. Schedule C, Profit and Loss from Business, or
  3. Schedule F, Profit and Loss from Farming.

Aczel claims that, as a rule, as your deductions approach 50% of your income, your audit likelihood rises. He lists precise ratios based on a study of 1,200 audit cases. For example, he claims that taxpayers filing a Schedule C are rarely audited if they claim expenses of less than 52% of gross business income, but are often audited when claiming expenses of more than 63%. If you include a Schedule A with your tax return, Aczel claims you are safe from an audit if your deductions are less than 44% of your gross income. While his book is interesting, don’t use it as a manual to avoid a tax audit. I say if you are entitled to a deduction, take it, no matter what the chances of audit are.

As your Income Increases, so does your Audit Likelihood

If you regularly earn over $100,000 per year, your probability of an audit has increased every year over the past decade. And when your time does come, expect it to cost you—five out of seven people who are audited owe additional taxes. A few people get tax refunds after an audit, but don’t count on it. The amount of money the IRS assesses in audits is 32 times greater than the amount given back.

The Audit Burden is on YOU, not the IRS

Federal courts have long held that if the IRS determines at an audit that you owe taxes, there is a rebuttable presumption that the determination is correct. This means that you have the burden of proof when up against the IRS. Critics have said that it really means you are guilty until proven innocent. While this is the standard in audits, it is not the standard in court proceedings where the IRS has the burden of proof. If you take the IRS to court, the government must show that you were wrong on a disputed factual issue, not vice versa 

If your dispute gets to court, however, the burden shifts to the IRS under certain conditions. Proving the correctness of your tax return may not be that easy. The IRS wins over 80% of all audits, mostly because taxpayers can’t properly verify the information on their tax returns. IRS auditors say that the biggest reason for adjustments is poor record keeping, not taxpayer dishonesty.

Please Audit Me!