"There are several ways a return can be selected for audit and the first way is what we call computer-scoring-termed DIF, or Discriminate Information Function," says Nancy Como, small-business/self-employed examination policy senior program manager for the IRS. "It's sort of a random selection. The IRS evaluates tax returns based on IRS formulas, and this is based on deductions, credits, exemptions with norms for taxpayers in each of the income brackets."
The actual scoring formula to determine which tax returns are most likely to be in error is a closely guarded secret. But Nath, a Washington, D.C.-area tax attorney, says it's no mystery that the system is designed to screen for returns that could put more money in the government Treasury.
How do your deductions compare?Tax experts believe one discriminate function component looks at average deduction amounts. This allows IRS examiners to spot inconsistencies, such as a high mortgage interest deduction and low income.
Tax specialists at CCH Inc. examined 2006 return statistics, the latest complete data, and came up with the following itemized deduction averages. These are for illustrative purposes only. CCH experts note that the IRS takes a dim view of taxpayers who base their claimed deductions on these figures. The numbers can be useful, however, in giving you a general idea as to whether certain deductions on your return might seem out of line.
How do your deductions compare?
Allison Einbinder, owner of Dollars & Sense, a tax and accounting firm in Oakland, Calif., recommends that all filers review the differential comparisons. How you stack up against a national standard, she says, will give you an idea of whether the IRS might take a closer look at your return.
So what is likely to trigger a discriminate information function red flag?
- Higher incomes.
- Income other than basic wages, for example, contract payments.
- Unreported income, such as investment returns.
- Home-based businesses, especially when in addition to salary income, and home-office deductions.
- Noncash charitable deductions.
- Large business meal and entertainment deductions.
- Excessive business auto usage.
- Losses from an activity that could be viewed as a hobby rather than a business.
- Large casualty losses.
Returns claiming the earned income tax credit, designed as a tax break for lower-income wage earners, also catch IRS eyes. The credit's complexity often results in legitimate mistakes on returns. Some filers, however, have been caught making false claims to increase the payment the credit provides.
Don't cheat yourself Don't let fear of a potential audit discourage you from filing for credits or taking legitimate deductions.
Although some tax return actions are likely to flag your return, Nath says that doesn't necessarily mean you'll be audited.
Even if your return is questioned, it's not a foregone conclusion that you'll end up owing the IRS. As long as your deductions and expenses are legitimate and you have documentation, Nath says, they will be allowed.
The groundwork you put into preparing your return will pay off in an audit situation. "Be confident in what you entered," says Einbinder. "That's easy when you have good records to support your tax return entries."