The primary objective of the Internal Revenue Service in “picking” tax returns for audit is to promote increased voluntary compliance.

The IRS uses computers and, to a lesser degree, manual identification to pick returns for audit. Tax returns are picked by IRS Campuses or Area Offices – the former IRS Service Centers. The returns are then further picked for correspondence, office, or field audit.

A computer program known as the DIF System (Discriminant Function) is used to identify tax returns. It uses a mathematical formula that assigns weights to certain return characteristics. Returns are ranked in numerical sequence based upon their score (highest to lowest). The highest scores have the most audit exposure.

The DIF System scores all individual returns, corporation returns with no balance sheets or assets under $10 million, and all S corporations with assets under $10 million. It also scores partnership returns, but it is believed the system may also use other criteria.

Over the years, the IRS has continually developed and changed its concentration regarding particular audit issues. Years ago, it used the “prime issue list” – an IRS guess of which tax items of income or deductions would produce the greatest results. In March 2007, the IRS decided to use a tiered classification system and placed audit issues into three tiers. Then in August 2012, the IRS stated it would no longer use the tiered system. While a new approach has not yet been announced, the items in the respective tiers still have significant dollar potential assessment. They include some of the following:

  • The domestic production deduction
  • Nonqualified deferred executive compensation plans
  • Backdated stock options
  • Mixed service costs regarding inventory costs
  • Research and experimentation credit claims
  • Foreign earnings repatriation
  • Stock-based compensation
  • Deferred home construction contracts
  • Use of gift cards to defer income

Even after returns have been selected for audit, taxpayers may still avoid being audited if the IRS auditor believes the audit result would not produce enough tax.

The IRS has a policy against conducting “Repetitive Audits.” However, the IRS does not have records readily available to determine if a proposed audit would be a repetitive audit. Taxpayers should immediately respond to the initial IRS contact letter and indicate they were audited in either of the two preceding years and the result was a no change or a small tax adjustment. If the response is received before the initial interview, the audit notice will be withdrawn.

The normal statute of limitations is three years from the due date of the tax return. Presently, the IRS follows a 26 month audit cycle for individual tax returns and a 27-month cycle for business income tax returns. This essentially means that for most income tax returns, if they are flagged for audit, the audit will be conducted within two years of filing the return.

The Whistleblower Awards Program has two types of informant awards. The first has been in place for years. The IRS will pay cash – up to 10 percent of the tax collected – for information it deems “necessary.” The second type of award resulted from the 2006 Tax Act. To qualify, business returns must be at least $2 million and for individuals the income adjustment must exceed $200,000 for any taxable year. The amount of the award will be at least 15 percent, but not more than 30 percent, of the collected proceeds. The IRS considers the value of the information provided in determining the percentage to be awarded.

For more information, contact us at Email or 215.441.4600.