How Does IRS Decide Who To Audit?

May 28, 2013

The Internal Revenue Service is living up to its reputation as a bully.   While the current scandal involves applications for tax-exempt organizations, many Americans are questioning IRS procedures.    Everybody agrees that partisan and political targeting is wrong, but the scandal leads to other questions.   How does the IRS select who gets audited?   What are the normal lawful methods for determining who gets audited?


Believe it or not, the first method is called random selection.   However, the audit decision is not truly random.   While returns are selected at random, not all selected returns are audited.   There is a process by which the IRS determines which returns deserves closer scrutiny.    Which returns advance to examination?   How do they make that determination?    Statistics.


The IRS has been conducting audits for decades.    They have collected data on taxpayers from everywhere from Honolulu to Hoboken, from every profession from Avon Lady to the zirconium miner.  With all of this data, the IRS has developed sophisticated statistical models to determine what is “normal.”


For example after decades of auditing traveling salesmen, the IRS has a pretty good idea what normal range of travel expense for meals for a salesman if he earns, $35k, $50, or $100k annually.    If a taxpayer claims more than the normal range, the return will be sent to an experienced auditor for review to see if the aberration is worth further investigation.


A second method for audit selection is document matching.     Most of us receive a W-2 or 1099 of some kind at the beginning of the year.   When your employer, mortgage bank, or investment firm mails that form to you they also mail a copy to the IRS.  If you make an error inputting the information onto your tax return or forget to report one completely, it is very easy for the IRS to catch.   The IRS already has the information reported directly from the source.    In many of these cases a streamlined automated adjustment is made.  A notice of the mismatch error is issued and a correction is proposed without additional questions.   The notice informs you of the right to dispute, but quite often the error is admitted.   The tax is paid, with interest and accuracy penalty.    However, significant underreporting of income can lead to a broader examination.


Under a third method, a taxpayer can be drawn into an existing audit of another person.  For example, if one partner in a business is audited, the audit may expand to include all partners because the possible changes will affect all of the partners.   Similarly, an audit may expand to include different parties to a business transaction because the transaction needs to be treated the same by all parties to the transaction.


It is this related person audit selection process which the current scandal raises concerns.   Were individuals audited because they were associated with the targeted non-profit organizations?    Many taxpayers believe this to be true.   Only time and a proper investigation will tell.


If you find yourself selected for audit you will be wise to consult a professional.   Contact Tax Armory to see if we can help you.