First of all let’s start with the basics… What is the purpose of a tax audit?
The purpose of a tax audit is to determine the correctness of a tax return. People make the mistake of believing that their tax return has been selected for audit because they made a mistake on their return. They’re under the assumption that the IRS found the mistake that’s why they’ve been targeted and now they somehow have themselves convinced that they’re going to owe more money just because the return has been selected for audit. The good news is that’s not (necessarily) true.
There can be some circumstances in which a tax return is selected because of a mistake. When we’re talking about the examination process that’s not what happened. What actually happened is the computer looked at your tax return found some question(s), not necessarily a mistake, but a question. That question is what gave rise to the examination.
What Type of Audit is This?
There are two different types of audits. One is a correspondence audit whereby you will interact with the IRS through the mail and possibly over the telephone. The second type of audit is a face-to-face audit.
Before any tax return is selected for audit, every single tax return filed with the IRS goes through a very detailed screening process within the IRS super computer. This screening process looks for a number of things. Many correspondence audits can be generated through the math error program, where there’s just a simple math error on the tax return. Yes, simple math such as addition and subtraction errors are a giant cause of IRS correspondence audits.
The automated under-reported program is responsible for millions of notices every year to taxpayers. These notices basically that say that the IRS has information in their super computer that shows you made X dollars. However, the information on your income tax return is different (meaning lower) than the amount of income other entities reported paying you. For example, if you file an income tax return that says you earned $50,000 last year but the information provided by other institutions shows $70,000 was reported under your name and social security number. That is going to be a problem for you in the future. You can expect to receive an under-reporter notice from the IRS in a the foreseeable future.
The substitute for return program, also known as SFR program, is a similar program for people that do not file a tax return at all. The IRS received information that you earned income but didn’t file a tax return. The IRS will be notifying you that income was reported and you are expected to file your income tax return.
The IRS also has a what they call an electronic fraud detection system that looks at various elements of tax returns to determine whether there’s a potential for fraud.
Remember, the correspondence examination program is a program specifically designed to audit tax returns by correspondence only and not face-to-face. Ultimately, the IRS computer system for some irregularity in your income tax return. It is the computer that flagged your return for audit and not a live human being sitting in some dark room with no windows that is out to get you.
The face-to-face audits make up the smallest component of the IRS audit system that take place throughout the year. The entire IRS audit department may select tens of millions of tax returns to be audited. The large majority of those are audited through the electronic process and only a small percentage of those are actually face-to-face.
When the IRS talks about its audit coverage it’s always referring to face to face audits and not the correspondence program audits. Correspondence program audits are up in many cases by three and four digit percentage increases over the past number of years. Meanwhile, face-to-face audits continue to decline in actual numbers. Through budget cuts, retirements, etc., the IRS doesn’t have the manpower and or the resources required to audit face to face. Simply put, the IRS can cover a lot more ground through the through the correspondence audit program than it can through the face-to-face program.
Of the tax returns selected through the face to face program, about 65% of those or just about two-thirds of them are selected through a program called the discriminant income information system also known as "The Diff Program". This program compares every line of your tax return with national and regional statistical averages per person in your same income category and profession. If any one line of the return is out of sync with those the difference is scored. This is called ”The Diff Score” and the higher the score, the more likely you are to be audited by the IRS.
About two-thirds of all the returns are selected for face-to-face audits come through “The Diff System.” The rest of the face-to-face audits come through very specific compliance initiatives. That is to say these are these are specific programs that the IRS is looking for a particular type of tax return for a particular reason. For example, non-filers (of course) are always at the top of the list. The IRS is always looking for Non-filers. Additionally, the IRS is looking to conduct audits to get non-filers back into the system and get these delinquent returns filed.
The IRS continues to look at flow-through entities such as subchapter-S, LLC’s and Partnerships. To be clear, the IRS is looking at the income on the entity return vs. the income on the taxpayer return. With a flow-through entity the taxpayer doesn’t report the gross income of the entity, the taxpayer only reports the net income and that’s what shows up on his tax return.
Profit motive issues of always been a high-profile for the IRS when they’re looking at schedule C businesses that report a loss year after year. Schedule C Business is always at risk of an audit. The IRS is going to look at gross income and deductions of the business.
Employment tax enforcement is another thing that generates face-to-face audits with businesses looking for employment tax compliance. Offshore audits are a big thing as well I also spent the last ten years or so screwing itself into the ground trying to track down all of the people that have offshore assets and so these offshore audits.
What about Appeals?
The final point to know and fully understand is the decisions of Tax Auditors is never final. The tax auditor does not have the power to put anyone in jail, he doesn’t have the power to lien and/or levy any assets, he doesn’t even have to have the power to change the tax return without the consent of the taxpayer! All this examiner can do is make recommendations that this or that deduction be disallowed for whatever reason and that is subject to appeal process.
Your right to appeal is absolute and not conditional.
Furthermore, your right to appeal applies to every tax situation and not limited to tax audits. For more information you can reference the Bill of Rights Act of code section 7803 which is the taxpayer Bill of Rights is not codified into law and that gives you the right to challenge the position of the IRS, to be heard, and to appeal the decision of the IRS in an independent Forum.
If all this seems overwhelming, confusing or you are just in plain “panic mode” give me a call to discuss your personal situation. I will always give you an honest assessment and you most like permanent outcome. I will never “sugar coat” the situation and I will tell you like it is. I can be reached at (877) 782-9383 or my personal cell phone number (714) 876-4702