Although there has been much publicity about the IRS targeting specific groups, individuals and political organizations, what is more troubling is the quiet expansion of the IRS workforce under the Obama administration and the impact this hiring has had on the audit rates of affluent and upper middle income ads Americans. Over the last several years, the IRS has added more than 5,000 revenue agents to its employment ranks. While it has been politically un-savy to raise marginal rates of taxation, our politicians have been able to boost total tax collections by both increasing enforcement through additional audits and by hiring additional revenue officers to collect unpaid taxes. Why not, it has been estimated that the IRS earns an 18 to 1 rate of return on every dollar that it invests in audit and collection activities.
The IRS also recently competed a study of 46,000 taxpayers to determine who’s cheating and where they cheat. This study identified a tax gap of approximately $345 billion dollars and determined that as much of two thirds of this gap comes from small business owners, entrepreneurs, investors and professionals. As a result, we now have a redirected IRS that is moving 30 percent of its workforce out of audits of large corporations and is now using these auditors to target the small business owner and self employed individual.
Here are some more troubling statistics. Each year, the IRS reports its audit rates in a book called the “IRS Data Book”. Here is what we have uncovered. Some businesspeople file individual returns, and those with incomes higher than $1 million have experienced a 94 percent increase in the number of audits as a percentage of total returns filed in this income category. The IRS now has a team, nicknamed “the wealth squad” dedicated to auditing this group of taxpayers. Millionaires now have a one in eight chance of being selected for audit. This trend is also trickling down to more moderate income businessmen. In fact, those with incomes $200,000 and higher have seen a 36 percent increase in their coverage rate since 2009.
Audit proofing ones tax return is now as important as annual tax planning. Field audits, where a revenue officer visits your place of business, on average cost $8,000 or more in professional fees to resolve not to mention the interest, penalties and back taxes that get assessed.
The Audit Selection Process
Before identifying the techniques to reduce your chances of being selected for an audit, it is important to have an understand- ing of the process the IRS uses to select individual returns for examination. While the IRS has developed many resources to select returns for audit, perhaps the best known is the discriminant index function (DIF) system, which the IRS has relied on for decades. This system uses mathemati- cal formulas, typically ratios of expenses to deductions, to score returns based on their audit potential. Here’s how the process works. Once your return is e-filed or transcribed by hand, the numbers are crunched by computers at the Martinsburg West Virginia National Computer Center. What results is something called a “DIF” score. The higher the DIF score, the greater the potential of bringing in additional taxes during an examination. Accordingly, the IRS strives to audit the higher-scored returns first because of the expectation of getting more revenue per dollar of audit time invested.
DIF scores are developed and updated pe- riodically from an analysis of a series of intensive audits, conducted every few years, called the Taxpayer Compliance Measurement Program (TCMP). In a TCMP audit, the IRS will analyze every item on the tax return, including proof of income. IRS computers analyze two primary measures in determining DIF score: total positive income and total gross receipts. Total positive income is the sum of all income items on a return. With regard to personal income tax returns reporting business receipts (Schedule C and Schedule F) gross business income rather than net income is the primary focus in DIF scoring. The reason for this is that The IRS believes that business gross receipts are better indica- tors of audit dollars than net business in- come reported on the return. For non- business tax returns, other items on an individual’s return will act as red flags (i.e., high DIF Scores) alerting the IRS to consider sending the taxpayer a written inquiry or worse, conducting an examination of that taxpayer’s return. Once the returns are scored in Martinsburg, they are sent back to the service cen- ters and ultimately hand screened for audit selection. This selection process does not even begin until after the end of June, over two months past the end of the April 15 deadline. The first step occurs when computer selected returns are arranged in batches of examination class, a method used to categorize returns by the amount of income reported. All returns are placed into one of 12 classes based on their total positive income (TPI) for individuals or total gross receipts (TGR) for businesses.
Throughout the year, district IRS offices place orders with the IRS service centers for returns to audit. The service center then pulls those returns that are above a specific DIF cutoff score and sends them to the district office. Districts are required to order returns numerous times over a twelve-month period so that all tax returns, regardless of their filing date, have an equal chance of being delivered to the district for classification, a manual selection procedure performed by revenue agents called classifiers.