The one weapon of intimidation the IRS holds over the U.S. population is the threat of an income tax audit. The vast majority of Americans will never be audited. However, for taxpayers with higher incomes, the chances of an audit is greatly increased.
The IRS runs many audit programs that target various industries and types of taxpayers. The main factor that determines whether an income tax return is audited is based upon an IRS metric known as the Discrimination Function or DIF score. Each tax return is given a DIF score through a confidential algorithm. Generally, returns with questionable income and expense amounts will receive a higher DIF score. The higher the DIF score, the higher the chance of audit.
Every year the IRS publishes the audit statistics for the prior tax year. The 2015 statistics report shows there were more than 150 million personal and business tax returns filed last year. The vast majority of these returns are personal income tax returns with income under $200,000. The audit rate of those returns is less than 1 percent.
The IRS has found that auditing higher income tax returns provides more bang for the buck. For tax returns that show more than $200,000, but less than $1 million, the audit rate goes up to 2.61 percent. That equates to roughly one out of every 38 tax returns. For taxpayers that show over $1 million of income, the audit rate jumps to around one in 10 returns.
Higher audit rates are bad news for wealthier taxpayers because the amount of additional tax generated after the audit can be huge. That is because those higher income tax returns generally have multiple sources of income and large businesses as well as rental expense deductions. All those elements are ripe for audit.
Most audits boil down to the investigation of questionable deductions, proof of those deductions, unreported income and personal expenses claimed as business deductions. Also, a taxpayer can expect the IRS to apply interest and a 20 percent penalty on any additional tax generated from the audit.
When the IRS initiates an audit, it is usually focused on one tax year. Unfortunately, the IRS often opens up other years during the course of the audit. This means the audit could generate three or more years worth of additional tax. The result could be a tax bill in the hundreds of thousands of dollars.
Income tax returns are not the only ones subject to audit. The IRS frequently audits estate tax returns, business and employment tax returns. Audits of the latter can have devastating results if a business treats its workers as independent contractors when they are really employees. The IRS makes the business pick up the tab for all the tax and wage withholdings that were not paid.
What to do if you’re audited
Audits might sound scary, but there is hope. First, make sure you have a good tax return preparer whom you can trust to give you solid tax advice. This will likely prevent an audit in the first place. Avoid preparers who say they can get you a good deal on your return. Only the IRS will get a good deal if that return is audited.
Second, if you plan to take a risky position on a return, think about getting a legal opinion first. If the position taken is not accepted by the IRS on audit, a legal opinion will generally save you from the 20 percent or more tax penalty the IRS would otherwise assess because you have reasonable cause for relying on the advice of a tax professional.
Lastly, if you are audited, make sure you have professional help. A tax professional can act like a firewall between you and the IRS.
In addition to the IRS, taxpayers must also worry about the California Franchise Tax Board. The FTB does conduct its own audits but generally relies upon the results of an IRS audit. Once the IRS assesses additional tax after audit, it will share that information with the FTB which will then assess additional state income tax.
If you are currently going through an audit, we recommend you speak with a tax professional or tax attorney and get some help. Proper representation can limit the amount of tax you will owe. Taxpayers who fight the results of an audit in the IRS Appeals Division or Tax Court usually can settle with the IRS for a lower amount than originally assessed.