Newsletter
How the IRS selects returns for audit, part 1
IRS audits happen. They can be annoying, even nerve-wracking, but understanding how IRS selects returns for audit can help relieve some of that stress.
The IRS has four methods for selecting returns for audit:
- Statistical analysis
- Missing information from third-party reporting
- Taking a questionable tax position
- Reliable reports raising suspicion
This part discusses the first method, statistical analysis. Future posts will look at the other methods.
Statistical analysis: DIF and UIDIF scores
The IRS receives hundreds of millions of filed returns and other forms yearly. Given this volume, it cannot possibly review each return manually, so it relies on statistics.
The IRS looks for two sets of issues: first, any glaring errors, omissions, or anomalies based on prior year returns and similar returns from other taxpayers; and second, unreported income.
A computer program—the Discriminant Inventory Function System (DIF)—scores each return after processing for the first set of issues. A second program—the Unreported Income DIF (UIDIF)—scores the return for the potential of unreported income.
Returns with high DIF or UIDIF scores likely face a manual examination by an IRS revenue officer. That examination could result in a notice via snail mail indicating a proposed change to your income tax liability. The taxpayer then has some time either to respond with substantiation or an explanation for the original return or to accept the proposed changes and pay the additional tax, along with any applicable penalties and interest.
Mitigating DIF and UIDIF issues
While we can't know for sure what will trigger higher DIF and UIDIF scores, knowing the logic of these programs helps us understand what makes a return more likely for examination.
For every return I prepare, the first step of reviewing the return before filing is to compare the current year's figures with those from the prior year. While no one expects the numbers to be precisely equal every year, significant changes should come with an easy explanation.
Sometimes that explanation needs to be made in a written disclosure. IRS Form 8275, Disclosure Statement, provides a mechanism for providing explanations. While including this form probably will not avoid a high DIF or UIDIF score, it may provide the necessary context to satisfy a revenue agent manually examining the return.
Of course, an audit may still happen. In this case, you can either substantiate the figures or argue the position taken. If the audit issue is a position taken, then either substantial authority or a reasonable basis, adequately disclosed, is required to prevail (more on these terms later).
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