This article is the first article in a multi-part series of articles that I will be doing on IRS audits. The purpose of this series is to demystify the audit process, inform readers about how audits are conducted, and provide readers with an understanding of what to expect if selected for examination. This article begins the series with a discussion of how taxpayers are selected for examinations, and the different types of examinations that the IRS conducts. In Part II, which will be published next month, we will examine the audit process in depth. Part III will then conclude the series with a look at special types of audits, including partnership audits and employment tax audits.
The U.S. tax system is unique in that it is a voluntary reporting system reliant largely on taxpayers self-reporting their liability to the IRS.1 Taxpayers do this (mostly) once a year by filing annual returns.2 To keep everyone [shivering in fear] honest, the IRS selects a certain number of returns for audit each year, and the total is allocated among the IRS’ various divisions, which each set their own strategic compliance priorities.3 The vast majority of examinations originate from one of two divisions: The Small Business and Self-Employed Division (“SB/SE”) and The Large Business and International Division (“LB&I”).4 SB/SE is responsible for examining individual taxpayers and small businesses. LB&I is responsible for examining large corporate and partnership returns.
The IRS does not announce the criteria it uses to select returns for examination, and those criteria change over time. The following, however, are some of the factors that can influence selection:
- Discriminate Information Function (“DIF”) Scores.5 A major factor in selection is the DIF score of the return. DIF Scores are three-digit scores assigned to each tax return by a multi-factor computer algorithm. “[The DIF program] scores returns by assessing patterns of deviation from expected ranges. Returns are divided into classes reflecting income and other characteristics. The items on each return are then analyzed through formulae designed to detect variations from amounts and relationships normal to the return’s class. The scores from these formulae are added to yield a DIF score.”6 The scores are confidential.7 A return with a high DIF score is more likely to be selected for examination. The IRS uses DIF scores as a preliminary screening tool.8 Returns with high DIF scores are examined by IRS personnel who ultimately decide whether the return is to be audited.
- Information Matching. Employers and other third-party payors are often required to file information returns with the IRS regarding payments made to taxpayers.9 IRS computers match the information reported on these returns with the information reported on the taxpayer’s return. If there is a discrepancy between the information reported on the returns, the IRS may simply send the taxpayer a letter requesting an explanation. If there are multiple discrepancies, however, the IRS may conduct a more extensive examination of the return.
- High Income/High Net-Worth. Generally, the audit rate rises as the taxpayer’s economic level rises. The larger the net worth or income of a taxpayer, the more likely the IRS will audit the taxpayer’s return. Audits of high-net worth taxpayers have been conducted by the Global High Wealth Industry Group within the LB&I Division. The Global High Wealth Industry Group consists of specialized teams of lawyers, economists, accountants, engineers and others with experience examining complex business and wealth management structures. Audits conducted by the Global High Wealth Industry Group can be extensive and expansive, and they may last many years.10
- Return Items. The IRS knows that there are certain items for which errors are more common. Returns claiming these items involve a greater risk of examination. Examples of these items include the earned income tax credit, home office expense deductions, and listed transactions.
- Infected Returns. Sometimes a return is audited because of its relation to another return that is picked up for examination. The other return could be one filed by the same taxpayer in a previous year or one that was filed by a partnership or s-corporation whose items flow-through and are reported on the individual taxpayer returns. If an examination of the taxpayer’s return for one year indicates multiple discrepancies of items that were reported on the taxpayer’s returns in multiple years, the IRS knows that the same discrepancy probably exists with other returns as well. Accordingly, it may broaden the scope of the audit to include the returns for those prior years.
- Whistleblowers. Sometimes third-parties tell the IRS about alleged wrong-doing. Congress has encouraged this by authorizing payment of rewards to whistleblowers whose information results in successful adjustments.11
Types of Examinations
The IRS conducts three principal types of audits: correspondence audits, office audits, and field audits. In addition, the IRS conducts specialized audits of partnership returns, estate and gift tax returns, and employment tax returns. These specialized audits are the subject of a separate article in this series. The focus here will be on the principal types of audits identified above and discussed in detail below:
- Correspondence Audits. Correspondence audits are the most common type of audit conducted by IRS.12 Those audits are usually conducted by lower level IRS employees at IRS service centers located in Memphis, Tennessee, Cincinnati, Ohio, Ogden Utah, and a few other locations throughout the United States. Correspondence audits are usually initiated by a letter from the IRS inquiring into a delinquent return or a discrepancy on a filed return. The taxpayer is asked to respond by mail, explaining the situation and providing documentation in support of its position on the return. Typically, the scope of the examination is limited to the one or two items that triggered the return for selection. However, the examination may be expanded based on information developed during the audit. Correspondence audits are limited to certain specified items. If a correspondence audit turns up information that would justify broadening the scope of the exam beyond the covered items, the case is transferred to a revenue agent for more extensive investigation. A transfer may also occur if requested by the taxpayer.
- Office Audits. Office audits are conducted at IRS field offices by tax compliance officers and revenue agents. Office audits may be conducted for examinations of individual and business taxpayers. Office audits often involve more complex issues than those presented in correspondence exams, and they usually entail some face-to-face meeting with the taxpayer or the taxpayer’s representative. The scope of the office audit is usually limited to one or a few issues and generally involves only one meeting. Again, however, the possibility exists that the audit may be expanded if the information provided to the revenue agent indicates that further investigation is warranted.13
- Field Audits. Field audits are the most comprehensive and rigorous types of audits. These audits are conducted principally by revenue agents, but may also involve economists, engineers, lawyers, and others within the IRS. These audits usually take place where the taxpayer’s books, records, and other source documents are located. Although this is usually the taxpayer’s residence or principal place of business, it could also be the offices of the taxpayer’s representative or return preparer. Unlike office audits, which generally involve only one meeting, field audits may tax place over several weeks, months, or years.
In sum, a small number of taxpayers are selected for audit every year based on a number of factors, including, DIF scores, information matching, net income and net worth, items claimed on the return, reportable transaction disclosure filings, other returns under examination, and information provided by whistleblowers. There are many types of audits. Individuals are most likely to encounter a correspondence audit. The audit is likely to be limited to one or a few specified issues, but the audit could expand based on the information developed during the examination. Next month we’ll look deeper into the audit process.
- Helvering v. Mitchell, 303 U.S. 391, 399 (1938) (“In assessing income taxes, the Government relies primarily upon the disclosure by the taxpayer of the relevant facts . . . in his annual return. To ensure full and honest disclosure, to discourage fraudulent attempts to evade the tax, Congress imposes [either criminal or civil] sanctions.”).
- In 2017, the most recent year for which statistics are available, there were a total of 190,613,300 income tax returns filed by U.S. taxpayers. IRS Data Book 2018, Table 2 (2018) (available at https://www.irs.gov/pub/irs-soi/18databk.pdf) (the “IRS Data Book 2018”).
- The IRS audited almost 1,000,000 of those returns in 2017, or about 0.5% of all returns filed that year. IRS Data Book 2018, Table 9a (2018). The SB/SE exam plan is based on long-range coverage objectives and on resources requested in the Congressional budget. Beginning in FY 2016, the exam plan has two major components: number of return closures and number of return starts. From the approved SB/SE exam plan, staff years are allocated to areas and campuses. Planning and Special Programs (PSP) Territory Managers are responsible for preparing the area response to the draft exam plan following instructions from headquarters. IRM 126.96.36.199 (Oct. 25, 2017).
- There were 150,043,227 individual income tax returns filed in 2017, 0.6% of which were audited by the IRS. In comparison, 1,826,883 corporate returns were filed in 2017, and 0.9% of those returns were audited. IRS Data Book 2018, Table 9a (2018).
- See generally IRM 188.8.131.52. (Oct. 19, 2017).
- David M. Richardson, Jerome Borison, and Steve Johnson, Civil Tax Procedure 95 (2d ed., LexisNexis 2008); see also IRM 184.108.40.206(2) (Oct. 19, 2017) (describing DIF as a mathematical technique used to score income tax returns for examination based on formulas developed from national research project data and indicating that a higher DIF indicates a greater audit potential).
- IRC § 6103(b)(2) exempts DIF scores from disclosure to taxpayers and others under the Freedom of Information Act or otherwise. See also IRM 220.127.116.11(3) (Oct. 19, 2017) (“DIF mathematical formulas are confidential and for official use only. The DIF score assigned to a return should not be disclosed.”).
- David M. Richardson et al., Civil Tax Procedure 95 (2d ed., LexisNexis 2008).
- These information returns include Form W-2, which is filed by an employer, and reflects, among other things, the wages and salary paid to the employee and the tax withheld by the employer; Form 1099-INT, which is filed by banks, savings and loans, and other financial institutions to show interest paid to depositors, as well as tax withheld under the backup withholding rules, if applicable; and Form 1099-DIV, which is filed by corporations and show the amount of dividends paid to shareholders.
- IRM 4.52.1 (August 12, 2013). For an interesting article regarding the effectiveness of these audits see https://www.propublica.org/article/ultrawealthy-taxes-irs-internal-revenue-service-global-high-wealth-audits.
- See IRC § 7623 (authorizing rewards for whistleblowers).
- About 70% of all examinations conducted by IRS in 2017 were correspondence audits. IRS Data Book 2018, Table 9a (2018).
- See IRM 18.104.22.168. (Oct. 19, 2017).