The Discriminant Index Function

Any tax relief attorney would love to know exactly how the IRS selects returns for audit, but the IRS only gives hints here and there, leaving us to piece it all together ourselves.  A recent TIGTA audit report offers some insight into the process:

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The IRS developed a variety of sources to select returns for audit. The IRS strives to select for audit those returns for which its examiners are likely to find areas of noncompliance and recommend changes to one or more items reported on the return. One audit source is the Discriminant Index Function (DIF) system, which the IRS has relied on over the years to help decide how to best allocate its audit resources. The system uses mathematical formulas to calculate and assign a score to returns based on their audit potential. The higher the score, the greater the chance an audit will result in recommended changes to the return.

~ TIGTA Report No. 2012-30-062 (June 21, 2012)

So, we know there are mathematical formulas involved.  We know the IRS is looking for returns with errors or “areas of noncompliance.”  And we know that one of the resources the IRS turns to for determining which returns to select for audit is the DIF.  There appear to be multiple formulas and multiple systems involved in the audit selection process. Continue reading “The Discriminant Index Function”

IRS Secrets

In-N-Out has its secret sauce and its secret menu.  Google has its secret search algorithms.  Well, guess what?  The IRS has its secrets too.

For example, everybody dreads the IRS audit, but nobody can tell for sure how to avoid them.  Sure, there are risk factors.  For example, high income taxpayers are more likely to be audited, self-employed’s are more likely to be audited than w-2 employees, and returns that have been amended are more likely to be closely examined than other returns.  However, IRS audit risk analysis is an imperfect science.  Even though it is very common for taxpayers to ask their tax attorney about their individual chances of being audited, tax professionals are understandably reluctant to give a straight answer . . . because they just don’t know.

Robert Wood is a prominent San Francisco tax attorney — one of the leading authorities in his field.  He writes a tax column for Forbes.  In one of his recent articles, he talks about whether or not the risk of audit increases when a taxpayer files an extension.  He thinks it does not, although he points out that other tax professionals disagree.  Interestingly, Mr. Wood does not cite any Revenue Code section, IRM section, or anything.  This is just his opinion based on his 30+ years of experience.

Even if there is a secret IRS audit formula, I’m sure it’s updated regularly to keep people on their toes.

IRS Audit Rates

Tax relief for the wealthy does not have much popular support these days.  And apparently the IRS feels the same.  The IRS recently reported that audit rates for individual taxpayers earning over $10 million has nearly tripled since 2009.  If you’re one of the .01 percent who makes that kind of money, then you have a 29.93 percent chance of being audited.

I know how some people are going to read this headline.  Some people are going to think that they are safe because they earn a lot less than $10 million per year.  If the IRS is focusing its efforts and manpower on examinations of the ultra wealthy, then that means audits of returns filed by the average Joe are decreasing, right?

Wrong.  The overall audit rate remains constant at 1.11 percent.  Maybe you like those odds.  Well, before you do anything you’ll regret later, be aware that income is only one factor that the IRS looks at when determining who to audit.  Furthermore, I’m not certain that these statistics include the so-called correspondence audits, which are becoming more and more common these days.