What causes or triggers an IRS audit?

By Jason Watson (Google+)

There are several reasons why an audit might fall into your lap:

Random: The percentage of random audits is very low, but still exists.

Computer Scoring: All tax returns are scored by the Discriminant Function System (DIF). Basically the IRS establishes a norm, and checks to see if your tax returns fit the norm. The system also rates the potential for adjustments based on historical data and past IRS experience. In other words, if the IRS has a good chance of putting more money in their pocket based on your DIF score, your tax return goes into the “maybe” pile.  Your tax return also gets assigned a UDIF score as well which is the potential that you have unreported income.

The variables and formulas used to determine your DIF score is like the NOC list in Mission Impossible.  But here are some focus areas according to other tax professionals and media outlets-

• Large Changes in Income: Historical data of your income is maintained by the IRS and the Social Security Administration.  If you have a large increase in income, the IRS will further check to see if the increase came from wages, capital gains, small business income, etc.  Wages aren’t necessarily a concern since taxes are withheld and reported, but other sources of income are.

• Self Employed or Small Business Losses: The IRS despises small business losses, and despises hobbies even more (read our article on Business vs Hobby at wcginc.com/Hobby.pdf).  Since history has proven that a lot of taxpayers are gaming the system for tax sheltering, self-employment income (and most cases, self-employment losses) is being scrutinized.  Remember, the basic premise of a business is the reasonable expectation of earning a profit.  If you can’t demonstrate that premise your small business losses will be deemed a hobby and disallowed.

• Deductions: If your deductions such as mortgage interest or charitable contributions are outside the average for your income range, you could trigger an IRS audit.  Don’t be afraid to take the deduction if it is legitimate, but ensure that it is allowed and keep good records.  You might be mailing them in.

• Rental Losses: This is a relatively new focus for the IRS since over the past few years several taxpayers are unable to sell their houses.  While rental losses are fairly straightforward, it remains an area that the IRS is currently paying attention to.In addition, the IRS is targeting those investors who are claiming a real estate professional status to avoid passive loss limitations. See our article at-wcginc.com/REP.pdf

• Home Office Deduction: Audits based on home offices are not as prominent today as it was in the past since telecommuting including self-employed taxpayers is more common.  Having said that, a lot of taxpayers still claim a home office deduction when it is clearly not allowed according to the IRS.  Commonly a taxpayer will have another office where they perform substantial administrative or managerial activities, work at home a couple of days out of the week, and then claim a home office deduction.  See our What are the rules on a home office deduction?.

• 100% Business Use of a Vehicle: Let’s face it, to have a 100% business use of a vehicle that you own personally is rare- commuting and personal miles are nearly impossible to avoid.  Regardless, keep detailed mileage records.  And if you do have a 100% business use vehicle that is not associated with a business, be prepared to demonstrate your claim and substantiate your mileage deduction.

• Meals, Entertainment and Travel: These expenses have commonly been abused by past taxpayers, and the IRS has historical data showing the averages as compared to income depending on your profession.  The IRS also has the average increase in tax liability based on past examinations.  Keep very detailed records if you are claiming these deductions- you might be sending these in too.

Information Matching: Most W2s and 1099s are electronically transmitted to the IRS.  If your tax return is missing a W2 or 1099, or if the amount you report is different than the amount the IRS has in their database, your tax return will be adjusted or audited.

Related Examination: If your business partner’s individual tax return is examined and a particular issue or transaction is discovered, your tax return might be examined as well.  This is not limited to business partnerships- any transaction or agreement between you and another taxpayer that causes a taxable event on two different tax returns might flag you if one tax return shows a discrepancy.

Abusive Tax Avoidance Transactions: Certain promoters and participants involved in abusive tax avoidance transactions have found themselves in trouble.  From there, the courts and other enforcement agencies have provided lists of names based on credit card data, summons and other testimony to allow the IRS to follow up.  So you might simply be guilty by association.

Large Corporations: The IRS examines many large corporate tax returns on an annual basis.

Other: Field IRS offices in conjunction with local agencies identify certain tax returns for examination based on local compliance initiatives, tax return preparers or specific market segments.