Income tax audit

In the United States of America, an income tax audit is the examination of a business or individual tax return by the Internal Revenue Service (IRS) or state tax authority. The IRS and various state revenue departments use the terms audit, examination, review, and notice to describe various aspects of enforcement and administration of the tax laws.[1]

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Purpose

The purpose of a tax audit or a return examination is to determine whether reports filed with the taxing authorities are correct.[2] The tax agencies identify and resolve taxpayer errors.[3]

Selection methods

There are several different methods used to select individuals and businesses for examination.

Third party documentation

Employers and financial institutions, among other organizations, are required by law to send documentation (W-2's and 1099's, for example) to the IRS. The IRS uses software to ensure that the numbers on a tax return match the numbers the IRS receives from third parties. If the documentation does not match, the return may be examined.[4]

DIF score

When a tax return is filed, the IRS uses computer software called the Discriminant Index Function System (DIF) to analyze the return for oddities and discrepancies.[5] Once the return has been processed through DIF, it is given a score. If the DIF score is high enough (i.e. a large amount of oddities or discrepancies are found), that tax return may be selected for examination. The formulas the IRS use to create the DIF software and analysis are a closely guarded secret.[6]

UIDIF score

Filed tax returns are also subjected to an evaluation called the UIDIF, or the Unreported Income Discriminant Index Function System. This evaluation involves the analysis of tax returns based on a series of factors to determine a tax return's potential for unreported income. Returns that are found to have a high UIDIF score (i.e. the likelihood of unreported income) and a high DIF score may be selected for examination. The IRS formulas used to calculated UDIF are secret, but it is commonly thought that the IRS uses statistical comparisons between returns to determine UIDIF potential.[7]

Random selection

The IRS selects a certain number of income tax returns to be audited each year through random selection.[4] No errors need to be found for the Enforcement branch to examine a tax return. Random selection exams tend to be more extensive and time-consuming than other forms of review.

Controversy

The practice of random selection has been a source of controversy for many years. The practice was suspended for a short time in the early 2000s amid criticism that the audits were too burdensome and intrusive. The IRS revived the practice in the fall of 2006.[8]

In April 2019, Propublica reported that IRS audit selection methodology, with its emphasis on Earned Income Tax Credit (EITC) claimants, resulted in a higher audit rate of low-income African-American in U.S. counties located in the Southern states, Hispanic taxpayers in counties along the Texas-Mexico border, and certain counties with a high percentage of Native Americans.[9]

Taxpayer rights & tax audit representation

When a return is selected for examination, the taxpayer has certain rights during the process.

Taxpayer rights

Each state will have its own version with respect to state taxes. With respect to U.S. federal income taxation, the taxpayer has the following rights:[2]

  • A right to professional and courteous treatment by IRS employees.
  • A right to privacy and confidentiality about tax matters.
  • A right to know why the IRS is asking for information, how the IRS will use it and what will happen if the requested information is not provided.
  • A right to representation, by oneself or by an authorized representative.
  • A right to appeal disagreements, both within the IRS and before the courts.
  • A right to be provided with all information concerning with any changes on tax administration

A taxpayer is required only to submit the auditor information relating to the specific year listed in the audit notice.[10]

Tax audit representation

Audit representation, also called audit defense, occurs when a tax or legal professional stands in on behalf of a taxpayer during an examination. Federal law and all states allow a taxpayer to have an authorized representative. The representative must have permission to practice before the IRS or state, and specific credentials are required. The types of representatives who are allowed to represent taxpayers before the IRS in income tax audits include attorneys, certified public accountants (CPAs), and enrolled agents.[11]

References
  1. Income Tax Audit Hits One Of Every 47 Filers, The Robesonian, January 24, 1980
  2. "IRS Audits". IRS. 2012. Retrieved February 27, 2012.
  3. "IRS Data Book 2010" (PDF). IRS. 2010. Retrieved February 27, 2012.
  4. "Common Reasons for Tax Audits". Tax Resources, Inc. 2012. Archived from the original on March 21, 2012. Retrieved February 27, 2012.
  5. "How Income Tax Audits Work". How Stuff Works. 2007. Retrieved February 27, 2012.
  6. "How to Avoid an IRS Audit". Money Under 30. 2009. Retrieved February 27, 2012.
  7. "Why IRS Audits Occur". The Resource Blog. 2013. Retrieved January 7, 2014.
  8. Herman, Tom (June 13, 2007). "The Next Audit Scare". The Wall Street Journal. Retrieved February 27, 2012.
  9. Where in The U.S. Are You Most Likely to Be Audited by the IRS? By Paul Kiel and Hannah Fresques, ProPublica. Retrieved April 1, 2019
  10. Brabec, Barbara (Nov 26, 2014). How to Maximize Schedule C Deductions & Cut Self-Employment Taxes to the BONE -. Barbara Brabec Productions. p. 107. ISBN 978-0985633318.
  11. "Your Rights as a Taxpayer" (PDF). IRS. 2005. Retrieved February 27, 2012.

See also

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