Top Reasons for Tax Investigations and Audits
Speaking generally, there are two main reasons why taxpayers are selected for an IRS audit. The first reason is that the taxpayer holds certain characteristics that the IRS finds intriguing. The second reason is that the IRS found red flags in the form discrepancy in the information you submitted due to your failure to file or other problems with your taxes.
In some instances, taxpayer characteristics may mean that the taxpayer’s risk of committing fraud is greater than average. In other cases, taxpayer characteristics are targeted as part of IRS attempts to maximize the potential return on its audit dollar. That is, the IRS selects a high-income taxpayer since that is where the money is. For instance, taxpayers who reported $10 million or more in income for the 2014 tax year faced an audit rate of greater than 16 percent. By contrast, a filer reporting between $50,000 and $74,999 in income had only a 0.53 percent audit rate. Individuals with income in the single-digit millions also face an elevated risk of an audit with those taxpayers reporting between $5 million and $10 million in income facing an audit rate of 10.53 percent.
Similarly, taxpayers who are the owners of a small business, who are involved with a business dealing mostly in cash, or taxpayers who see big changes in their finances are also more likely to face an audit. Finally, in light of the IRS and DOJ push to stamp out offshore tax evasion, holders of foreign assets and accounts along with people who file international tax returns also face an elevated audit risk.
The second common reason why people face an audit is that the IRS identifies a problem with their taxes. All tax returns are scored according to a “Discriminant Function System” or DIF. The Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income. IRS personnel screen the highest-scoring returns, selecting some for audit and identifying the items on these returns that are most likely to need review. Thus, DIF and UIDIF act as a screening and identification mechanism such that IRS can allocate its audit resources to address taxpayers with a high likelihood of tax problems.
People who report zero income or fail to file taxes at all are much more likely to be audited. In fact, the audit rate for individuals reporting zero income is only surpassed by the rate of high-income taxpayers reporting income of more than $1 million. Other mistakes that IRS computer systems are adept at identifying include failures to include all or some sources of income, deductions or tax credits out of step with those of similarly situated taxpayers, and failures to disclose foreign accounts.
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