IRS Audit Strategy : Who Gets Picked

I have often wonder how the IRS picks their victims to audit - well here is something to add to your collective memory when filling out your taxes next year.

Who the IRS Audits and Why
Source: "Taxes: Where Does IRS look for Cheats?" Politico, April 14, 2013.

April 17, 2013

A new study reveals where the Internal Revenue Service (IRS), the agency responsible for taxes, looks for tax cheats. The study, by the National Taxpayer Advocate, an independent office within the IRS, shows who should be most worried about being audited, says Politico.

• The study was conducted by analyzing confidential IRS data to show large clusters of potential tax cheats.
• The clusters then become the basis for how the IRS chooses who or what businesses to audit.
• Small business owners in the suburbs of Los Angeles, San Francisco, Houston, Atlanta and the District of Columbia are most likely to evade taxes.
• The study also showed that people who owned a construction or real estate business were more likely to alter their taxes than other business owners.

According to the IRS data, the likelihood of an audit increases with income, which is why many of the small businesses that are audited are in the wealthy suburbs of major cities.

• The IRS audits about 1 percent of tax returns every year and uses the study results to focus their efforts where tax fraud is most likely.
• The study used 2009 tax returns to examine sole proprietorships, which make up about 66 percent of all U.S. businesses.
• The businesses are evaluated by a computer, which calculates a Discriminant Inventory Function (DIF).

While the process is secret, it typically flags individuals who claim large deductions in relation to their income. The IRS says that auditing an individual with a high DIF score is very likely to result in a change in that individual's tax liability.

The difference between what taxpayers legally owe and what they actually pay is referred to as the tax gap, which was estimated at $345 billion in 2006.