The IRS developed a method of computer scoring called the Discriminant Function System (DIF) score which rates the potential for change based on past IRS experience with similar returns. The Unreported Income DIF (UIDIF) score rates tax returns for the potential of unreported income. The highest-scoring returns are reviewed by IRS personnel and from there some are selected for audit with pointers to items on the return that need review.
The IRS is most likely to audit returns with a high ratio of certain types of deductions to income. Three tax return schedules are critical to this process:
- Schedule A, itemized deductions such as medical expenses, unreimbursed employee expenses, state taxes, mortgage interest, and charitable contributions.
- Schedule C, profit and loss for unincorporated small businesses, and
- Schedule F, profit and loss for farms.
The IRS uses Automatic Underreporter Program (AUR) and Information Matching system. Employers, banks, brokerage firms, payers of independent contractors all file documents with the IRS and send the same documents – Forms 1099, W2, 1098, K-1, etc. to taxpayers. If you neglect to report any of the data on these forms, or report an amount different than what is on the form, the IRS picks up on it. Usually, it sends out a letter CP- 2000 relaying the information and billing the taxpayer for additional taxes. Sometimes an agent shows up on your doorstep.
Every year the IRS selects a particular industry for compliance examinations. In the last couple of years they have concentrated on foreign trusts with the idea of uncovering unreported income from offshore accounts. A few years ago they looked at attorneys incorporated as Sub S corporations attempting to reclassify dividends as wages for those who take low salaries but large distributions thus saving money on employment taxes. One year they went after servers in restaurants to collect on unreported tip income. Every year the agency chooses an industry to scrutinize based on suspected abuse hot spots.
Amended returns are often times flagged for audit, especially if the information you are changing involves increasing deductions in red flag areas such as travel, meals and entertainment and automobile expense.
Don’t be afraid to amend if you have cause. However, if you are amending your income tax return, be sure you can substantiate all deductions and income.