January 2015

Tax season is gearing up, an annual source of tension for many Americans. The Internal Revenue Service (“IRS”) looms in the background, with a mission to “Provide America’s taxpayers top-quality service by helping them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all”. Yet the benevolent vibe of the message is inconsistent with how most see the IRS. The fear of an IRS audit is a significant factor in motivating taxpayers to pay their taxes on time and accurately.

Yet only a relative few will actually experience an IRS audit. The IRS accepts most Federal tax returns exactly as they are filed. And many of the IRS enforcement activities are not the involved field audit one likely envisions, but merely a mailed notice of a change in the taxes owed (otherwise known as a correspondence audit) that may be a fairly minor amount or even result in a refund.

The IRS publishes an annual data book that reports on such items, with the most recent representing 2013 activity related to 2012 returns. The examination rates on certain types of entities can be summarized as follows:

Return Type Number Filed Number Examined Percentage Coverage Correspondence Audit Field Audit
Individual 146,819,000 1,405,000 1.0% 1,061,000 344,000
Estate/Trust 3,048,000 5,000 .1% 4,000 1,000
Taxable Corp 1,957,000 28,000 1.4% 2,000 26,000
S Corp (nontaxable) 4,476,000 19,000 .4% 1,000 17,000
Partnership (nontaxable) 3,550,000 15,000 .4% 4,000 11,000

 

Notably, the IRS tends to perform more field audits with corporations and partnerships, but relies more heavily on correspondence audits for individuals and estates/trusts. Once the IRS selects a return for audit, most audits find that more tax is owed:

Correspondence Field
Return Type % with Change Required Total Additional Tax Avg. Add’l Tax Per Return % with Change Required Total Additional Tax Avg. Add’l Tax Per Return
Individual 88% $8.46 billion $7,971 91% $5.59 billion $16,255
Estate/Trust 46% $.01 billion $23,997 89% $0.13 billion $639,965
Taxable Corp 70% $.05 billion $4,645 73% $16.64 billion $180,629
S Corp (nontaxable) 50% N/A N/A 69% N/A N/A
Partnership (nontaxable) 64% N/A N/A 53% N/A N/A

 

Generally individual taxpayers with higher adjusted gross income (“AGI”) are more likely to be selected for an audit:

AGI on Return % of Total Filed Examination Rate
All 100.00% .96%
$0 2.08% 6.04%
$1 to $25K 39.91% 1.00%
$25K to $50K 23.55% .62%
$50K to $75K 13.02% .60%
$75 to $100K 8.12% .58%
$100K to $200K 10.09% .77%
$200K to $500K 2.60% 2.06%
$500K to $1 million .41% 3.79%
$1-$5 million .19% 9.02%
$5-$10 million .01% 15.98%
$10 million plus .01% 24.16%

 

The IRS makes many of its audit selections by applying computer scoring. The Discriminant Function System (“DIF”) rates returns and provides an Unreported Income DIF score. IRS personnel will then further screen high scorers. While some returns are selected for audit based on random selection, there are some common issues that will often get your return flagged for further examination:

  • Mismatch with data the IRS already has from other sources, such as W-2s, 1099s, mortgage statements, etc. This should be easy to avoid by keeping documents organized and double checking your return for data entry errors.
  • Math Errors. Electronic filing has helped reduce this issue substantially.
  • Inconsistency with related parties/entities’ returns. This is difficult to prevent without access to the tax returns of others. However, you may still get a pass, as the IRS has not historically done well with capturing all inter-taxpayer discrepancies (as described in this related article on the alimony gap).
  • Operating outside of industry standards, especially with regard to often abused expense items such as travel, meals and entertainment and vehicle expenses. The IRS has a listing of average expense levels for every industry classification.
  • Ongoing, unsustainable losses in your business, which may suggest that personal expenses are being included.
  • Unusual or unrealistic deductions, such as very high charitable deductions relative to your income or a suspect home office deduction.
  • Complex issues in self-prepared returns. Professionals should do a better job than non-professional tax preparers, especially considering the intricacy of the tax code.

While there is no excuse for math or input errors, there are times when unusual expenses, ongoing losses or high deductions are simply an accurate reporting of legitimate activity. In such cases, one should consider including a brief explanation. A quick answer to what is likely to be a questioned item may get the return accepted based on a desk review rather than triggering a field audit. At the same time, over-explaining could pique additional interest, so stick to the relevant facts.

Fulcrum Inquiry performs forensic accounting and compliance-related accounting examinations