Who is most likely to be audited?

Discriminant Inventory Function

According to the Internal Revenue Service (IRS), tax returns are selected for audit by using a computer program called the Discriminant Inventory Function (DIF) system. This system gives each tax return a numerical score. Nearly all tax returns that receive a high DIF score are audited because the IRS believes that there is a good chance that after auditing high DIF score tax returns, there will most likely be a change in the amount of tax owed by the taxpayer.

While the IRS does not provide very clear information on how DIF scores are calculated, we do know that the DIF system compares your tax return to tax returns of other taxpayers in your income bracket. Assume Mary reports an income of $50,000 on her tax return, but then also claims charitable donation deductions totalling $10,000. Mary will most likely receive a high DIF score because it is unusual for taxpayers in her income bracket to donate 20% of their income. Also, the DIF system also compares how much income you report and how much income others in your neighborhood report on their tax returns. For example, if you live in an affluent area where the average income of the taxpayers is $200,000 a year and you report an income of $30,000, it will also cause you to receive a high DIF score.

Income Source

A high DIF score is not the only way to get audited; there are some taxpayers who are at high risk for being audited given their source of income. Taxpayers that are self-employed at high risk for being audited or by the nature of their job are at high risk for being audited because the IRS is suspicious that self-employed taxpayers deduct personal expenses by labeling them business expenses on their tax returns. Other taxpayers such as waiters and those who work in the gaming industry are also at a high risk for being audited because they earn income mostly in cash. Most recently, the IRS has been on alert for taxpayers that might be involved in committing financial fraud. Taxpayers who use offshore credit cards, have very high incomes, investors in abusive schemes, and those who fail to include certain sources of income are also at risk for being audited because the IRS is carefully monitoring their activities. The IRS can also audit taxpayers based on information received by third parties. For example, if your tax return does not match the information on your W-2 or Form 1099, that increases audit risk. Information from public records, newspapers, or anonymous sources can also cause the IRS to audit you if they suspect your return may contain inaccuracies.

While some taxpayers may be concerned about the possibility of being audited, the IRS does not have unlimited time to audit taxpayers. Under federal law, the IRS has only 3 years from the date the tax return was filed to conduct an audit.

Case Studies: Factors That Increase Audit Risk

Case Study 1: The DIF Score and Unusual Deductions

John Thompson, a self-employed consultant with an annual income of $80,000, filed his tax return claiming unusually high deductions for business expenses.

His reported deductions were significantly higher than what is typical for consultants in his income bracket. The IRS’s Discriminant Inventory Function (DIF) system flagged his return with a high score, indicating a higher probability of an audit.

Case Study 2: Offshore Investments and High Incomes

Emily Rodriguez, a successful entrepreneur, had substantial investments in offshore accounts and reported a high income of $1 million on her tax return.

The IRS closely monitors taxpayers who engage in offshore financial activities and those with high incomes. Emily’s tax return triggered suspicion due to the nature of her investments and the significant income reported, increasing her chances of being audited.

Case Study 3: Inconsistencies With Third-Party Information

Michael Cooper, an employee in the financial industry, received multiple Forms 1099 reflecting his investment income. However, Michael’s tax return failed to include this additional income.

The IRS cross-referenced the information from the Forms 1099 with Michael’s tax return and identified the discrepancy. Such inconsistencies between the reported income on the tax return and third-party information can lead to an increased risk of an audit.