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Audit Triggers

March 16, 2011

Tax returns are audited for several reasons, but the methods by which the IRS flags a return for audit are more limited. There are essentially two main ways an audit is triggered – (1) selection based on a closely guarded IRS computer scoring system and (2) selection based on mismatched information filings (i.e., W-2’s and 1099’s).The automated scoring system is known as the Discriminate Inventory Function System (the “DIF”).¹ This program compares your tax return to other returns deemed “normal” for people in similar tax situations. If the DIF finds discrepancies between your return and the return of other similarly situated people, it assesses a numeric value to that portion of your return. The higher the overall numeric value, the more likely your return will be flagged for an audit. Mismatched information filings means that the W-2, 1099 and other income statements do not match the income information filings with the IRS. Most of the time, the audit is triggered by the omission of a W-2 or 1099. The IRS may also audit a return if they receive third-party information which suggests noncompliance with the tax laws or inaccurate filings (i.e. newspapers, public records, individuals, etc.).² Having a return flagged for an audit does not necessarily mean your deductions, credits or overall tax liability is inappropriate or inaccurate. It does mean, however, that if the IRS does decide to audit you, you need to be prepared to substantiate the deductions and credits listed on your return. Here is a non-exhaustive list of items that might “trigger” an IRS audit:

• Business Deductions – The IRS might ask you to justify the $3,000 you claimed in telephone expenses when your business only brought in $10,000 in gross receipts. Whatever the reason, it is important is to keep track of receipts in order to be able to verify that these costs did in fact occur.
• Home-Office Deductions – The home-office deduction is more difficult to qualify for than most think. Before you begin claiming one-third of your home as a home office deduction, be sure to consult a professional. I have also touched upon the basics of this home deduction in an earlier post [read here]. Note – You cannot use my post to justify your use of a home office deduction. Doing that without further consultation with a professional would be foolish.
• Offshore Accounts³ – The IRS certainly wants to learn more about any offshore accounts held by taxpayers attempting to shield themselves from their full tax liability [read here].
• Full-Time Job with Schedule C losses⁴ – A trigger may occur if a person has a full time job with steady income and the person is filing a Schedule C with a loss.
• Carry-Back Losses⁵ – While certainly allowable, the IRS maintains a close eye on businesses that claim carry-back losses. It is important to have the appropriate documentation to justify such operation, and if legitimate you must claim it.
• The Sale of Home Exclusion⁶ – Even in this current housing market, some homes are still selling for a substantial value above their purchase price. The sale of home exclusion, for those who qualify, is up to $250,000 for a single taxpayer and $500,000 for taxpayers filing a joint return. You can see how the IRS would be interested in making sure you in fact qualified for this exclusion.
• Earned Income Tax Credit⁷ – As I mentioned in an earlier posting, the Earned Income Tax Credit is rife with abuse [read here].
• Charitable Contributions⁸ – If taxpayers actually donated the amount collectively claimed in charitable donations each year, I am convinced poverty and homelessness would have long been eradicated in the United States. The excuse I often hear is that the person donated out of the goodness of his or her heart. If so, then it follows that they would not be claiming a deduction either. I absolutely advocate being a Good Samaritan to others and it is not below you to ask for a receipt when doing so.
• Married Filing Separately⁹ – Married couples who file separately often turn in inconsistent returns. Inconsistent returns often means mismatched information filings and thus increases the potential for an eventual audit.

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