Minimize Your Chances in the IRS Audit Lottery – January 05, 2015 by Mike Kolk

Although most people would love to win “the lottery,” that’s not always the case, such as in Shirley Jackson’s like-titled story or in the more recent Hunger Games series. Likewise, the IRS Audit Lottery is one best avoided as well. As all of the 2013 tax returns have now been filed, the lingering question is: can your return rest in peace, or might it be brought back from the departed by the likes of an IRS computer program shrouded in secrecy? And is there any way to minimize that risk?

To give some perspective, the IRSprocessed somewhere in the range of more than 150 million personal income tax returns in 2014. Total IRS employment, as of 2012, was about 90,000 (but falling), and only a modest portion of those employees were actually involved in examining individual tax returns. With a shrinking staff responsible for filtering an overwhelming number of returns, there is still a heavy reliance on the Discriminant Function System (DIF) to determine which returns will be audited.

The DIF system ranks which returns get examined. It uses unpublished formulas to score tax returns for potential for changes or unreported income based on experience with similar returns. Once the IRS computer assigns a DIF score to a return, higher scored returns are sent in bulk to the Examination Division where they are reviewed by a human “classifier.” The classifier uses his or her judgment to determine which returns are sent on for an actual examination.

The mystery of the DIF process has been somewhat reverse engineered by statistics and other quantitative methods over the years. The IRS itself produces stratified results of its examination process each year based on income and other levels of differentiation, which also give a glimpse into the areas that garner most attention.

Even though there is clearly a political spin to areas of enforcement — think “kinder and gentler” IRS of the late Clinton years to President Obama’s focus on taxing high earners — there are tax return profiles that are far more likely to garner a higher DIF score and more likely to produce more scrutiny and get pushed forward by the classifiers. Here are a few of the flags:

  • Returns with itemized deductions over 40% of adjusted gross income or returns with Schedule C (unincorporated business) income greater than $100,000 (five times more likely to be examined).
  • Income from certain trades, such as building contractors or a business that primarily collects income in cash.
  • Significant charitable donations relative to your income.

Judge Learned Hand stated in 1934 that “Anyone may so arrange his affairs that his taxes shall be as low as possible...” And while the areas listed above may cause the IRS to take a closer look at your return, there's no reason not to take a deduction to which you are entitled or not enter into a building contracting business because of the potential for an exam.

There are things that can be done, however, that are controllable and may reduce exam exposure:

  • Account for all 1099, 1098 and K-1 forms to ensure they are reported on your return to match against those filed by the payor.
  • Explain any highly unusual item with adequate detail to help a classifier understand why it's correct.
  • Conversely, don't over explain areas that don't require it (this is the art versus science element of tax preparation).
  • Retain correct documentation for at least three years, especially in areas of greater scrutiny.
  • Report foreign bank accounts and other financial assets as required.

There is no sure-fire way to avoid an IRS examination, but there is also no reason to unduly fear one if selected. In many audit situations, a good advisory team can work successfully with IRS agents to get them the explanations and documentation they need and can help manage any proposed adjustments.

While there are lotteries we would all love to win, having your number pulled for the Audit Lottery is probably not one of them. Still, if it happens to you, getting your tax professional engaged early and having the right documentation will make it far less painful than being stoned to death to ensure a good harvest or being hunted through the forest as a “star” on a disturbing reality show. Remember that when the bill arrives.

We want to hear from you! We encourage you to comment below on this blog post, share it on social media or contact Mike Kolk at mkolk@cohencpa.com or a member of your service team for further discussion.

This communication is published by Cohen & Company for our clients and professional associates. Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this publication should be taken only after a detailed review of the specific facts and circumstances.