Risk of an IRS Audit
According to Dept. of Treasury data, the IRS examined slightly less than 1% of all individual tax returns, which is down from about 5% in the mid 1960's. So the chances that your tax return will be audited are pretty low.
But the chances of an IRS audit can increase substantially, depending on your income level, types of income, amount of deductions, your income earning activities and changes you have made since your last tax return was filed.
An IRS audit, while not on the list of fun things to do, is not something to be feared. If you have kept complete and accurate records of all of your deductions and have reported all of your income, you should be fine. In fact, in about 25% of audits, the IRS makes no changes or issues a refund.
IRS Audit Checks and Triggers
But before you can reduce your risk of an IRS audit, you need to better understand what the IRS looks for when they review tax returns.
Through a process called Document Perfection, every tax return is checked for errors in math and tax calculations and for clerical errors such as incorrect SSNs and addresses. If a mistake is detected a notice of the error and a recalculation of the tax due is sent to the tax payer. So obviously, checking your tax return information carefully before filing is a no-brainer.
Next, tax returns are run through what's called the Document Matching Program, which compares the information you report with the information supplied by your bank, your employer and others on forms W-2, 1099 and other forms and documents.
If you omit an item from your tax return which is picked up by the IRS' computers, the IRS will send a computer generated notice that includes a recalculation of your tax and the additional interest and penalties you will owe. Typically these notices are sent two to three years after the return in question is filed, so when you receive these, you will need to find your returns and records to verify if the IRS is correct in their assertions. Typically these omissions are honest mistakes by a taxpayer and, although the IRS maintains their position that they could asses a negligence penalty, the law does not allow them to presume negligence and automatically asses such penalties.
The final review is a mystical process called the Discriminant Function System (DIF). Basically the DIF is a computer program that assigns a numeric value or score of selected items on tax returns. When the total score of all selected items exceeds a minimum set by the IRS, the IRS computers will single out the return for a possible audit. The exact items and scoring convention is a more closely guarded secret that the formula of Coca-Cola, but some of the items believed to be on the list include:
- Large amounts of income not subject to tax withholding.
- Unusually large amounts of deductions claimed than seem reasonable when compared to your income.
- A large number of dependent exemptions claimed in conflict with reported SSNs, tax withholding allowances, etc.
- Indicating a change of address when not reporting a sale of your residence and not changing your home related deductions.
Check back in a few days when I'll write about a few things on tax returns that tend to draw additional attention from the IRS.
Ray Martin
View all articles by Ray Martin on CBS MoneyWatch»
Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.
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