(Part 3 – Audit Scores)
This is the last of three articles on how the IRS receives, validates, stores, and scores tax returns for audit.
– How efiled and paper-filed tax returns are verified, validated, and reviewed for accuracy.
– How tax returns are stored into master files.
– How IRS scores tax returns for audit.
Scoring system
The IRS uses a Discriminant Function System (DIF) to determine returns that are most likely to generate additional revenue for the government. Although the scoring is secret, the scoring is based on two factors: Total Positive Income and Total Gross Receipts. A return with a high DIF score is more likely to be audited, since such a score indicates a greater probability that additional revenue will be generated. The DIF score is based on statistical profiles developed through the National Research Program (NRP).
National Research Program (NRP)
The IRS developed a new NRP to replace the old Taxpayer Compliance Measurement Program (TCMP). NRP developed new audit criteria from a stratified sample of approximately 50,000 individual audits. Data obtained from the NRP audits are being used to score returns for audit.
Exceeding national averages attract audits
Taking deductions that exceed national averages increases your audit score. TIP: If you exceed the averages, opt out of efile – paper file and attach explanation of unusual amounts such as big donations or large medical bills.
Other sources of audits
Audits also come from matching programs, return preparer programs, claims for refund, or separate related-party audits.
Employment Tax (ET) audits
The main goal is to secure statistically valid information for determining the most noncompliant employment tax areas (home care industry for example). The IRS selected 2,000 taxpayers each year for the last three years to focus on worker classification issues – independent contractors versus employees (1099 versus W2).
Nation’s tax gap
The IRS estimated the nation’s annual gross tax gap (meaning the difference between what taxpayers should pay and what they actually pay) at $450 billion in 2006. The Treasury Inspector General for Tax Administration (TIGTA) indicated that the tax gap is even wider since the IRS formulas are outdated and unable to include much of the underground economy (workers and purchases paid by cash).
Tax Gap – Statistics show that:
– Failure to report income accounts for 80% of the total gap.
– Nonfiling and underpayment account for 10% each.
– More than 80% of individual underreporting comes from understated income.
– Most of understated income comes from business activities.
– ndividual income tax is the largest source of the gap, accounting for about 60% of the total gap.
– Underreporting is lowest where there is third-party reporting or withholding (W2 and 1099).
Future audits
The IRS Commissioner and the Treasury Inspector General for Tax Administration (TIGTA) have indicated that closing the tax gap has become a higher priority with increased document matching programs, expanded information reporting programs, and examination of high income individuals and Schedule C’s with a history of losses. All these factors lead to more IRS audits in the coming years.
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Victor Santos Sy, CPA, MBA, provides professional services in accounting and tax controversy including IRS audit defense and offers in compromise. He also advises clients on choices of entity including corporations for small businesses and LLCs for rentals. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation at 704 Mira Monte Place, Pasadena, CA 91101. The firm celebrates its 35th anniversary this year. You may email tax questions to Vic at [email protected]. You are welcome to visit our website for more than 300 tax tips at www.victorsycpa.com.