In an effort to bridge the gap between tax dollars owed and tax dollars collected, the IRS is tasked with both the collection of current taxes due, and, for some, the focus rests on key areas of non-compliance.
One of the chief strategies employed by the IRS to ensure individuals pay their appropriate share is an audit of a taxpayer’s return.
An audit is driven by various factors, and in many cases, they are done randomly. Certain items claimed on a return, as well as various attachments and schedules, all play into the mathematics behind a tax return potentially being selected for audit.
The IRS makes use of a tool called the Unreported Income Discriminant Index Formula, which rates the probability of inaccurate information in conjunction with the probability of income being omitted from the return.
For example, if a 1040-EZ tax return shows earnings from one W-2 only, and if the income reported on the return matches the income that has already been reported to Social Security and the IRS, then that return is a virtual guarantee to circumvent an audit.
On the other hand, a 1040 with various income sources, some of which cannot be backed by hard-copy documentation such as self-employment earnings, along with multiple credits and schedules which claim a large refund from paper losses such as non-verifiable investment loss, has a much better chance to be pulled for additional review.
With that said, here are four target areas that the IRS typically reviews for an audit.
High income, high risk taxpayers
Taxpayers with higher incomes generally file returns that are more complex in nature, and they also have a higher statistical ability to engage in pass-through activities, like shielding funds from taxation through the establishments of trusts and tax shelters, some of which may be illegal.
High income non-filers
Along those same lines, the IRS prioritizes individuals who have not filed a tax return yet have high income reported under their social security number. After multiple notices are sent out advising an individual of their legal obligation to file, the IRS will prepare what is called a Substitute for Return.
This assessment takes a straight tax on any and all income reported, and assumes a 100 percent gain on all investments. The return is filed using the exemption amount for one person, and no additional credits, deductions or dependents are allowed. The result is almost always a large tax balance, which the IRS will then begin collecting on. Once they do, taxpayers often file their own true and accurate “reconsideration” return.
High amounts of itemized deductions
Schedule A allows a taxpayer to itemize their own tax deductions rather than take the standard deduction based on their filing status. Items on the schedule are subject to limitations, but the amount of discretionary deductions and calculations can result in greater potential of error or fraud.
Unlike wage earning individuals, income earned directly by a taxpayer through self-employment is not subject to any system of verification. You are expected to report 100 percent of your earnings, and then you are free to deduct all legal expenses related to the production of income. Those who report inflated expenses that are disproportionate to the amounts earned, as well as losses year after year, are especially vulnerable to an audit.
More from this Contributor:
What to do if the IRS says they intend an auditing you
How to avoid being audited by the IRS
10 reasons why taxpayers owe the IRS