How Your Federal Return Is Initially Examined For Potential Audit
All federal income tax returns are added to what the IRS calls its Master File after they are checked for basic errors. From there the returns are scored using the Discriminant Function System (DIF) and then processed through the Unreported Income DIF (UIDIF).
The IRS’s Discriminant Function System (DIF)
The IRS’s Discriminant Function System (DIF) score rates specific tax criteria that are weighted for probability of evasion or error, based on past IRS experience of audits with similar returns, and having similar business or income activity codes.
A high score on the Discriminant Function System (DIF) means there’s a chance you underreported your income, over estimated your deductions, and that there’s a good probability of recovering additional taxes. If your score indicates a possibility that you didn’t pay enough taxes (the “potential for change”), it will trigger a review.
This system compares your reported income and deductions with other taxpayer returns that are in a similar tax bracket and/or profession. Claiming charitable deductions of more than 10% of your adjusted gross income, business expenses over 63% of your income, or Schedule A deductions that exceed 35% of your adjusted gross income are a few examples of scenarios that increase your DIF score.
The Unreported Income DIF (UIDIF)
The program used by the Internal Revenue Service (IRS) to compare all tax returns submitted by individuals to data sent in by third parties like banks, employers, and mortgage companies is known as IRS’s Automated Underreporter Program. The Unreported Income DIF (UIDIF) identifies returns that have unreported income.
The Automated Underreporter Program resulted in over $8 billion dollars of additional tax assessments of 1.5 million audits in 2022. One unique feature of this program is that it not only identifies taxpayers who underestimated their income it also identifies non-filers, people who fail to file a tax return.
Some of the data that the Underreporter Program receives from third parties includes:
- Form 1042-S (foreign person’s U.S.-source income subject to withholding)
- Form 1097-BTC (bond tax credit)
- Form 1098 series (including mortgage interest, student loan interest, and tuition payments)
- Form 1099 series (including interest and dividend distributions)
- Form 3921 (exercise of an incentive stock option under Section 422(b))
- Form 3922 (transfer of stock acquired through an employee stock purchase plan under Section 423(c))
- Form 5498 series (including individual retirement arrangement and medical savings account information)
- Form W-2 (wage and tax statements)
- Form W-2G (certain gambling winnings)
- Form SSA-1099 (Social Security benefit statement)
- RRB-1099 (payments by the Railroad Retirement Board)
- Form 8300 (cash transactions is excess of $10,000)
Only a small amount of the data the IRS receives is listed above. You can find the full list here.
20+ Reasons You Could Be Audited
- Unreported income
The IRS compares information supplied by third parties with what you report on your return. You will trigger an audit if you understate income reported to the IRS. There are a lot of other scenarios where you might receive income that isn’t reported to the IRS by a third party. If tips are typically in your profession, the IRS expects you to keep a log of those tips and report the tips as income. If you receive cash payments in your business, your income should match your bank deposits.
- Math errors
In 2022, approximately 16 million returns contained almost 17 million math errors. This included miscalculating credits, primarily the Recovery Rebate and Child Tax credits. For minor math miscalculations, the IRS might just ask you to correct your return.
- Claiming the earned income tax credit (EITC)
The IRS estimates that 21% to 26% of EITC claims are ineligible, and the National Research Program (NRP) estimates that approximately 50% of EITC claims have errors. EITC deductions had the second highest audit rate, at .77% compared to the .25% average.
- Claiming a loss on a hobby
Hobby expenses are no longer deductible; claiming business expenses on your Schedule A could cause problems, especially if you report a lower hobby income than the 1099 form the IRS received.
- Excessive Schedule A deductions
Deducting more than 35% of your total AGI for non-reimbursed employee expenses, donations, and medical deductions. Employee expenses and donations are compared with what other taxpayers in your profession and income are reporting.
- Home office deductions
To be allowed a home office deduction on your Schedule C, you have to work primarily out of your home and that you have a dedicated space used exclusively for this home office. Creative square footage claims can also hurt you. One simple Zillow search and the auditor will figure out that it’s unlikely your home office isn’t 800 square feet if the total square footage of your home is 1400 sq. ft.
- Excessive Schedule C deductions
The IRS uses occupational codes to measure average amounts of travel and other deductions by others in a similar profession, and a tax return showing 20% or more above that average could risk an audit. See further below for more information on cell phone and home internet business deductions.
- Charitable deductions
Deductions that exceed what other filers in your income range claim; the average is under 10% of AGI for all filers. For donated goods, take pictures. Keep a spreadsheet that shows the date donated, detailed description of items, and fair market value. Use purchase receipts for new items, thrift store values for common used items and completed eBay sales for uncommon items. For large donations such as cars or boats, print out the blue book value at the time of donation. These values depreciate by a large amount every year, so you could potentially loose thousands in deductions if you wait to print out the value. Conservation easement donations can get more scrutiny.
- Early withdrawals from retirement accounts
These withdrawals must meet certain criteria in order to avoid taxation and penalties. The IRS keeps an eye out for early retirement account withdrawals that don’t meet the criteria and are therefore taxable. If you take a withdrawal before you are 59½, those fund could be subject to an additional 10% penalty in addition to standard taxes.
- Not reporting foreign bank accounts
The Foreign Account Tax Compliance Act has strict reporting requirements for individuals and foreign bank accounts. You are supposed to report assets over $50,000. This amount should match what those financial institutions report to the International Data Exchange Service (IDES).
- High business expenses
Claiming deductions that are more than 63% of your business income could trigger an audit. Probably the best way to ensure you get audited is to list business deductions in excess of business income or show a loss more than 2 years out of every 5 years. Showing a negative gross income on your Schedule C is risky, especially if your cost of goods sold is higher than your sales. If you purchase goods but don’t sell them all in the same tax year, the remaining goods should be transferred to inventory.
- Dealing in cryptocurrency and other virtual currency
- High income
Earning more than $500,000 can increase your likelihood of an audit as the IRS is focusing more on high income individuals. This initiative has resulted in 1600 additional taxpayers receiving IRS notices in September 2023. The IRS has already collected $122 million just from 100 of those 1600 taxpayers. High wealth earners who have never filed and those who have failed to pay taxes they owe are under additional scrutiny.
- Excessively rounding up deductions
Seriously, there are more than a few tax court cases where individuals rounded up every single deduction to the nearest $100 to $500. If your donation was $236.73 you should round up to the nearest dollar ($237); please don’t put down $500. Excessive rounding either means you haven’t kept proper records and are guessing, or that you are trying to overstate your deductions (AKA fraud).
- Deducting more than 75% business use of home internet
Based on several tax court opinions, the allowable portion of home internet for business use at max has been 60%. They are just as stringent on business use of personal cell phone.
- Claiming 100% business use of a vehicle
If you’re going to claim 75% or more business use of your personal vehicle, be sure to have detailed travel logs that specify the dates, miles, and reason for travel. Per the IRS, “no deduction is allowed for vehicle expenses unless the taxpayer substantiates, by adequate records or sufficient evidence corroborating his own statements, the amount, time and place, and business purpose for each expenditure”.
- Participating in a tax shelter program…
…that uses a sketchy investment strategy. The IRS is strengthening its focus on “promoters and participants of abusive tax avoidance transactions”. This could include claiming a deduction for amounts paid as premiums for “insurance coverage” as a means of averting tax, investments in off-shore accounts and digital assets, and investments in certain conservation easement arrangements.
- Large corporations and complex partnerships
The IRS is increasing its efforts to ensure compliance by large corporations. This includes foreign-owned corporations, corporations taking large deductions and receiving large refunds. The also includes issues related to transfer-pricing, taking special deductions for producing goods in the US, and credits and/or loans.
- Having financial ties to someone with “tax issues”
These are called “Related examinations”, where the IRS might select your return when it involves issues or transactions with other taxpayers, such as business partners or investors, a tax adviser or preparer who is under investigation, and even former spouses whose returns were selected for audit.
- Discrepancies related to Third Party Data
In additional to taxpayer returns, the IRS processes 3.5 billion information returns from third parties. All this information is added to the IRS’s Master File. The IRS matches information reported by taxpayers against information reported by third parties, allowing it to identify potential fraud and noncompliance.
A few examples of over 50 types of third party data the IRS receives:
* If you deposit or pay over $10,000 in cash for business transactions, purchases, a car, or college tuition, those expenditures are reported to the IRS using Form 8300 or by FinCent Currency Transaction reports.
* Proceeds from real estate transactions.
* Cancellation of debt over $600
* Tuition statements and student loan interest statements
* Mortgage interest statements
What Happens When You Are Audited
By the time you are notified of an audit, the IRS will have already conducted a thorough financial analysis on you. They will have reviewed your sources of income to ensure it matches third party data. They will have also used comparable statistics to estimate your personal living expenses. This helps develop a profile of whether your income is enough to support your lifestyle. They will compare your Schedule A and Schedule C deductions to taxpayers in a similar profession or income range. They will also have developed a strategy for your audit which typically follows the recommendations in Audit Technique Guides (more on those below).
Depending on the complexity of your audit, they may also have obtained information about you from companies such as LexisNexis. These companies provide information such as such as real estate transactions, ownership data, liens, judgments, bankruptcy records, professional license information, DMV filings, voter registration, historical addresses and neighborhood income profiles, Secretary of State filings, UCC filings, Fictitious Business Name Information (DBA or doing business as), tax liens, SEC abstracts, boat registrations, FAA aircraft registrations, civil and criminal court data.
Your notification will include what type of exam will occur. An IRS examination may be conducted by mail (known as a a correspondence audit) or through an in-person interviews such as a office audit or field audit. The complexity of your return determines whether the audit is by correspondence or in person.
This type of audit represents about 75% of cases in 2019. The audit notification letter tells you which records will be needed, with instructions for submitting your documentation, and a toll-free number for questions. You aren’t assigned to a single examiner that oversees the entire audit process; instead you get whomever answers the toll-free number.
Generally, the questionable issues addressed in correspondence audits are EITC, additional child tax credit, American opportunity tax credit, medical expenses, contributions, taxes, or employee business expenses. The tax examiners that handle correspondence audits receive training on these issues but aren’t required to have accounting skills.
Correspondence audits are pretty straightforward; you are typically being asked to provide proof of the deductions or credits you claimed, pay additional tax, or provide copies of bank and/or credit card statements. In the event the IRS isn’t satisfied with the information provided, or additional areas of concern are discovered, they may decide to expand the audit.
In-Person Interview Audits
This type of audit may be at an IRS office (office audit) or at your home, place of business, or your accountant’s office (field audit). In 2019, 9% of audits were at an IRS office and 17% were field audits. In-person audits are reviews of taxpayers that are considered more complex than issues handled through correspondence audits.
An office audit is usually handled by Tax Compliance Officers (TCOs). TCOs receive more training than tax examiners and have some accounting training. The types of issues selected for an office audit are income from tips, pensions, annuities, rents, fellowships, scholarships, royalties, and income not subject to withholding; deductions for business related expenses; deductions for bad debts; determinations of basis of property; capital gain versus ordinary income determinations; and complex miscellaneous itemized deductions such as casualty and theft losses.
A field audit is usually used for more complex returns, where individual, corporate, and partnership returns are audited by a Revenue Agent (RA). Revenue Agents are highly trained and have substantial accounting skills. These types of audits might include include high income, high wealth taxpayers, cash intensive businesses, transfer pricing, executive compensation, research and development credits, crypto currencies, partnerships and flow through entities, micro captives, offshore transactions, and syndicated conservation easements. In tax court record proceedings, field audits were also used to determine business use of buildings as well as home office deductions.
What Should You Do If You Are Audited?
To get an idea of what will happen during the audit, search for the IRS’s Audit Technique Guides that related to your tax situation and industry (individual, business, self-employed, etc). These guides are used to train auditors and provide information on the audit examination process. The guides address steps for reconstructing income as well as defining which expenses are common for a specific field. As an example, you can view the audit guide for a child care provider here.
If you receive a notice of audit, you should carefully read what the IRS is requesting and how quickly they want a response. Depending on your circumstances, you may want to seek the advice of a tax attorney before taking any action.
If they are seeking specific documents or records, you should provide that specific information (again, refer to the advice of your tax attorney). It’s probably not a good idea to send in more than they asked for because you could potentially be opening yourself up to additional scrutiny.
You should also get a copy of your tax record transcripts from the IRS (see below).
You, the taxpayer, have the burden of proof
The IRS will be looking for receipts. If you don’t provide the requested documentation by the deadline provided, the IRS can summons the records directly from your bank or financial institution.
The summonses can also seek loan records; these records will typically contain any financial statements you provided to the bank regarding all your income sources as well as any assets you might have listed.
If they request records and receipts for deductions, you must be able to fully substantiate the underlying expense with credible evidence; a printout of your year-end credit card statement will not be enough. “Deductions are a matter of legislative grace, and taxpayers bear the burden of proving their entitlement to any deduction claimed”. “Credit card statements do not provide evidence of what the charges were paid for; it only informs us of the identity of the payee and the amount, date, and means of payment.”
It’s fair to say you shouldn’t be creating records in order to comply with information requests; you should have compiled most of that data when you prepared your tax return. The US tax court has taken issue with business records that were created solely for an audit.
“...Rather, he created them solely for use in the IRS examination. He offered no clear explanation as to when he made these entries, and he could not explain how he could have remembered these granular details many months or years after the fact.“
The US tax courts are also not too fond of records you manufacture:
“The amounts shown as “payments” are in a different font from all other numbers on the receipts. We conclude that these documents were photoshopped, with fictitious numbers being inserted as payments. Because these documents are not authentic, they must be excluded from evidence.“
What happens if the IRS wants your bank accounts
In some situations, the IRS will want to know about exact transactions in your bank accounts, or about other accounts that don’t show up on your tax returns or information statements. Most of the time, these are escalated inquiries that will come from a specific IRS employee during the audit even if you have a Correspondence Audit.
The auditor would be looking to see if you reported all your income. For example, if the revenue agent auditing you sees unexplained cash deposits in your account, he or she may suspect that you didn’t report all your income on your return. The IRS will perform a bank deposit analysis, and use referenced images of checks deposited into each account and determined the sources of the checks to identify unreported income.
In addition to looking at deposited checks to determine the source of the checks, an auditor might also use the contact information on the checks to reach out to the check issuer for additional information regarding the transaction.
Bank deposits are prima facie evidence of income, and taxpayers bear the burden of proving that a deposit is nontaxable or that the analysis is unfair or inaccurate. If there are large deposits in your accounts that weren’t reported as income, you will need to prove that those funds were not income-related.
If you don’t provide that information, the IRS can request it directly from your bank or other institutions by issuing a summons. You can contest the summons if you can show that the summons isn’t for a legitimate purpose or that the information is irrelevant to the audit. You can also contest the summons on the grounds that the IRS already has the information if you have provided full records.
Large deposits in your account could be from the cash sale of a vehicle; if that sale was less than what you paid for the car you don’t owe taxes. You might also have received money as a gift, or were repaid money that you lent, or even have cash from an inheritance. You’ll need to provide some sort of evidence or corroboration for each deposit.
Perhaps the cash gift happened right around your birthday or graduation? If your brother finally repaid the $7000 he borrowed and you don’t have an IOU or loan agreement as proof, ask him to write a statement about the loan. If the cash was from a relative that recently passed, a death certificate would be helpful. Regardless, you should try to provide information for every single deposit that wasn’t reported as income otherwise you will be required to pay taxes and a penalty on those amounts.
What else can the IRS look at?
An audit is usually pretty straightforward, but it can get complicated. If the information or documentation you supply (or fail to supply) leads an auditor to think that you are not being truthful, there are other areas they can to investigate. This is especially true if things don’t add up (ie several mortgage interest deductions but no reported rental property income).
If they have a reasonable indication that there is a likelihood of unreported income, they might request other data such as loan documents and review any financial statements you provided to the lender in order to get approved. They might even expand the scope of the audit to other tax years.
State tax returns can provide additional information.
Additionally, there are many public resources that auditors can use to gather information about you if they feel it’s necessary.
Property Tax Assessor records can be helpful in determining the assessed value of a specific home by its address. In some localities, these records can be searched by a taxpayer’s name to determine how many properties a taxpayer owns.
If divorce proceedings are public, these can reveal information related to asset distribution which can help identify additional income or assets.
Google Street View can be used to see if you really did put an addition onto your shop 3 years ago.
Even your social media accounts may contain information to help gather information. Did you claim that your boat is used 100% for business entertainment purposes? If your social media account feature you taking frequent family vacations on your boat, you are probably going to lose that deduction.
What Is Fraudulent Intent?
In considering fraudulent intent, US tax courts have recognized “badges of fraud” that include:
(1) understatement of income
(2) inadequate records
(3) failure to file tax returns
(4) implausible or inconsistent explanations of behavior
(5) concealment of assets
(6) failure to cooperate with tax authorities
(7) filing false Forms W-4, Employer’s Withholding Certificate
(8) failure to make estimated tax payments
(9) dealing in cash
(10) engaging in illegal activity
(11) attempting to conceal illegal activity
The tax court considers does consider a taxpayer’s education and “sophistication”. But they have taken the position that misleading statements during an audit, even from an unsophisticated taxpayer, may indicate fraudulent intent.
Types of IRS Tax Penalties
The IRS assessed $73.6 billion in civil penalties in FY 2022. These are some penalties that the IRS might assess in addition to under-payed taxes.
- Information Return applies to taxpayers who don’t file or furnish their required information return or payee statement correctly by the due date, up to $630 for not filing
- Failure to File applies when you don’t file your tax return by the due date. up to 25% of your unpaid taxes.
- Failure to Pay applies when you don’t pay the tax you owe by the due date. The Failure to Pay penalty is one-half of one percent for each month, or part of a month, up to a maximum 25% of our unpaid taxes.
- Accuracy-Related applies when you don’t claim all your income or when you claim deductions or credits for which you don’t qualify. Accuracy-Related Penalty is 20% of the portion of the underpayment of tax that was understated on the return.
- Erroneous Claim for Refund or Credit Penalty applies when you submit a claim for refund or credit of income tax for an excessive amount and reasonable cause does not apply. In cases of erroneous claim for refund or credit, a penalty amount is 20 percent of the excessive amount claimed.
- Failure to Deposit applies when you don’t pay employment taxes accurately or on time. up to 15% of your unpaid deposit plus interest
- Tax Preparer Penalties apply to tax return preparers who engage in misconduct.
- Dishonored (bounced) Checks or Other Form of Payment applies when your bank doesn’t honor your check or other form of payment.
- Underpayment of Estimated Tax by Corporations applies when you don’t pay estimated tax accurately or on time for a corporation.
- Underpayment of Estimated Tax by Individuals applies when you don’t pay estimated tax accurately or on time as an individual.
- Section 6663 imposes a penalty of 75% of an underpayment of tax if any part of the underpayment is attributable to fraud.
- International Information Reporting applies to certain taxpayers who fail to timely and correctly report foreign sourced financial activity.
Regarding Audits: How far back can the IRS go?
There is a 3 year statute of limitations for audits and most audits are filed within the last two years.
The 3 year limit doesn’t apply in the case of fraudulent returns or failing to file a return all together. The IRS has 6 years if you understated your gross income by 25% or more.
If the IRS can prove that a return was false or fraudulent with the intent to evade taxes, the period of limitations does not run out and it can audit an unlimited number of your returns.
If you overestimated deductions or understated income and there’s a potential to recover back taxes, they might review previous returns.
If the IRS asks your consent to extend the 3 year deadline, negotiate that the extension so it is limited to the specific issue at hand and that the extension be limited to 6 to 12 months (depending on how long you’ll need to provide the requested documentation).
Get a copy of your tax record transcripts from the IRS
This transcript will show most of your information statements that are reported to the IRS (w-2s, 1099s, Social security administration income). This information might be helpful if you want to get a sense of some of the information that the IRS already has in hand and to ensure that what they have received is accurate; especially if you’ve been the victim of identity theft. The transcript may also prove useful if you are contesting a summons. https://www.irs.gov/individuals/get-transcript
If you are contesting an audit determination, you will need documents to prove your position. If you are contesting how a deduction was excluded/modified or other specific change was applied, you will need to find relevant tax code, regulations or previous case law to support your argument.
How much of your cell phone bill can you deduct?
You can only deduct the portion of your cell phone allocated to business use.
The IRS calculates this portion using a 168 hour week (24×7). If you say you work 40 hours a week, you are only entitled to claim 24% of your cellphone bill (40 divided by 168). You can increase that if you allocate additional hours to times you aren’t using your phone at all for personal and business use. If you say that you sleep 8 hours a day and you spend roughly 2 hours a day preparing and eating food, you reduce the week to 98 hours (14×7). This would result in business use of your cell phone of 41% (40 divided by 98).
Here’s are some excerpts from US tax court opinions as reference:
“…that makes 89 hours per week he spent working and 79 hours per week he spent not working. We appreciate that he did not use the … service for nonbusiness purposes during the entire 79 nonworking hours in each week, but petitioner did not submit evidence allocating this time to other activities such as eating and sleeping … Accordingly, petitioner has established the business purpose of 38.3% ..”
“petitioner did not provide credible evidence of a business purpose for her cell phone bills. Although cell phone bills were not subject to the strict substantiation requirements under section 274 during the year at issue, petitioner was nonetheless required to provide evidence establishing how much of the bill was for personal as opposed to business use.”
“With respect to the cell phone expenses, petitioner credibly testified that 50% of his phone use pertained to (business). The other 50% was for personal use. We further find that 50% of services to which the expenses relate were ordinary and necessary business expenses”
Please note that the above information is not nor should be used for tax advice. Please consult a tax professional.