HOW THE IRS DECIDES TO AUDIT

While enjoying a leisurely breakfast at Shirley’s Family Restaurant for the first time in months this past April 15^th my eyes were drawn to the title of a front page item from the Associated Press in The Times Tribune titled “How IRS Decides to Audit”.

The sub-headline read – “Study finds clusters of likely cheats”.

The item reported –

“A new study by the National Taxpayer Advocate used confidential IRS data to show large clusters of potential tax cheats in {the wealthy suburbs of Los Angeles, and communities near San Francisco, Houston, Atlanta, or Washington DC}.  The IRS uses the information to target taxpayers for audit.”

And –

“The study also looked at tax compliance in different industries, and found that people who own construction companies or real estate rental firms may be more likely to fudge their taxes than business owners in other fields.”

Contractors cheat on their taxes?  Duh!!!

The article eventually goes into detail about “how the IRS decides to audit”, which has not changed for decades –

“Each tax return is assigned a score.  The higher your score, the more likely you are to get audited because, according to the IRS, the more likely you are cheating on your taxes.

The score is called the Discriminant Inventory Function, or DIF.  A high DIF score does not guarantee you are a tax cheat, but the IRS claims it’s reliable.”

The article quotes a Turbo Tax representative to explain how one would get a high DIF score –

“If you’re reporting $8,000 of charitable contributions when you only making $50,000, that’s a red flag.”

What does this tell us?  If your report income of $50,000 on your Form 1040, and you actually did donate $8,000 to a qualified church or charity, you should not deduct this $8,000 on your Schedule A?  If you ask me – definitely no.

You should never NOT claim a legitimate and documented tax deduction simply because you think it will result in an IRS audit!  You are entitled to the deduction by law – so you should take it.

John Q Taxpayer earns $50,000 per year.  In 2013 he received a large inheritance from an uncle.  This inheritance was not taxable, and was not required to be reported on his 2012 Form 1040.  JQ is a volunteer at his local pet shelter, and knows that the shelter is trying to raise money to purchase a larger property.  JQ donates $8,000 from his inheritance to the shelter, a legitimate 501(c)3 tax-exempt charity.  The charity gives JQ a letter of thanks and acknowledgement, which includes the statement that no goods or services were provided in exchange for the donation.  Why shouldn’t JQ be able to claim a tax deduction for his gift?

He should!  What all this talk about DIF scores means to JQ is that he should make sure to keep the letter of acknowledgement from the shelter in a safe place.  Perhaps he should attach a copy of the letter, and a copy of his cancelled check, to his 2013 Form 1040.

As I have said in previous posts –

·      If your deduction is legitimate and you have sufficient documentation to prove its authenticity in an audit then what is the problem? While nobody wants to be audited by the IRS, an audit is not something that must be avoided at all costs – it is merely an inconvenience.

·      If you fail to claim a legitimate deduction or credit you have, in effect, audited your own return and disallowed the deduction – neither of which the IRS may actually do.

You should not be afraid to deduct an item because it appears to be too big.  You should be sure that you have all the proper documentation for the item and keep it in a safe place.

A high DIF score, or individual item, does not guarantee an audit.  Over the past 40+ years I have often had a client claim a legitimate deductions that I was certain the IRS would question, based on the % of the deduction to the client’s income. But they never did.

Click here to download recent IRS audit and enforcement statistics.

The article concludes by telling us –

“DIF scores can vary across industry, according to the study by the Taxpayer Advocate.  For example, people who owned construction companies were more likely to have high scores.  Lawyers, accountants and architects, and people who provided other professional services were more likely to have low scores.”

Are lawyers, accountants and other professionals more honest than contractors?  Not really - they just know how to cheat more effectively {just kidding}.

TTFN