Who gets audited?

This post comes from Jim Wang at partner blog Bargaineering.

Doing your taxes is never fun. Even if you ignore how you must spend a couple of hours filling out boring forms, finding documents and researching deductions, there’s always the fear that you’ll be audited. I remember having the most vanilla tax returns back when I was a teenager, the 1040-EZ, and even then I was irrationally concerned about an audit.

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The reality is that very few people get audited -- just a couple percent each year -- and some of them deserve it. As much as we might like to think of the IRS as some cruel, emotionless monster trying to make the lives of hardworking Americans as miserable as possible, it's not. It's trying to collect tax revenue so the government can continue to provide the services hardworking Americans need.

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How does the IRS decide whom to audit? It’s actually very straightforward.

In 2006, the IRS published a page on its Web site that details exactly how employees determine which tax returns to audit. It comes down to these four main ways (for individuals):

• Computer scoring. I listed this one first because it’s the most interesting of the four reasons. Tax returns are “scored” using two systems -- Discriminant Function System (DIF) and Unreported Income DIF (UIDIF). The Discriminant Function System score gives the IRS an indication of the potential for change in tax due, based on IRS experience. The Unreported Income DIF, as you can imagine, scores the return on the potential for unreported income. The higher the score for either, the more likely the return will be reviewed.
• Information matching. This is an obvious reason because it’s the easiest to catch. The IRS receives the same W-2s and 1099s that you do, so it’s trivial for IRS employees to compare the two totals. If they don’t match, they investigate.
• Related examinations. Beware who your friends and business contacts are. If their returns are audited and their returns include transactions with you, your return may be audited as well.
• Potential participants in abusive tax avoidance transactions. The IRS may get information about promoters of and participants in various schemes and select a return for audit based on that information.

Most of the red flags you read about fall into one of the first two categories. For example, if you underreport your income, you could trigger both the UIDIF score and the information-matching reasons. If you participate in an abusive tax avoidance transaction and the guy who planned it gets caught, you’ll probably get audited. 

Related reading at Bargaineering:

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