With the 2022 tax filing extension season coming to a close on October 16, one may be wondering how vulnerable their 2022 tax return is to an audit. Spanning my 10 years as an auditor with the IRS, one of the most frequent complaints I heard from the taxpayer was about “just my dumb luck, being audited.” To be clear, there is nothing dumb or unlucky about your tax return being selected for audit by the IRS. The media often report that a mere 1% of tax returns are audited, giving one the impression that taxpayers have a mere 1% chance of being audited. But this notion is flawed on two counts. One, this oft-quoted 1% rate is an annual rate, so that were we to extrapolate this over one’s tax-filing lifetime, each taxpayer would stand a greater than 50/50 chance of being audited. But the more pronounced reason this oft-quoted statistic is flawed is because the IRS does not randomly select returns for audit, so that each return does not stand an equal chance of being audited. Rather, the IRS uses a complex computer program that ranks each tax return based upon the likelihood the taxpayer had under-reported income, over-reported deductions, or both.
This ranking results in a score referred to as the “DIF score,” so that the higher the DIF score the greater the likelihood the taxpayer owes additional taxes and, by logical extension, the greater the likelihood of being audited. This program’s algorithm is a closely guarded secret, even to the vast majority of the IRS personnel! Indeed, IRS folklore has it that only a handful of IRS employees are privy to this formula. I remember attending a shabbaton several decades ago at a time that coincided with my first year at the IRS. I recall sitting at a table where a bookish-looking gentleman proudly mentioned to a young lady at our Shabbos table that he was one of only a few IRS employees who was privy to the DIF formula. To his surprise, the young lady appeared glassy-eyed. Apparently, she did not appreciate the impact the DIF score had on her chance of being audited.
As closely guarded the DIF algorithm may be, it is fair to conclude the odds of a W-2 wage earner who does not itemize his deductions of being audited is exceedingly low. So then, who does have a greater likelihood of being audited? Based upon my experience and on conventional wisdom, the following taxpayers stand a disproportionately greater risk of being audited:
One who reported a disproportionately high deduction for charitable donations relative to the reported income.
One who operates a business either as a sole proprietor, independent contractor, a member of an LLC, partnership or as an S corporation, especially one who reports disproportionally high business deductions relative to their reported business receipts.
One who operates a “cash business” such as a restaurant or a home improvement contractor.
So then, what is an honest taxpayer to do? Playing the audit lottery is not the recommended approach. By that I mean hoping to escape an audit by playing the odds. This approach relies too much on wishful thinking. Rather, I recommend you take a preemptive approach, on the chance your return will be selected for audit:
Maintain accurate books and records.
Retain receipts and other source documents.
Include explanatory statements to preempt IRS questions.
Maintain a separate business bank account for one’s business operations.
Deposit all business receipts into the business bank account.
On a related note, I am frequently asked how long one should retain tax records. Because the IRS has a statutory right to audit a tax return for three years, the logical answer would be at least three years. And since most books and records are retained in an electronic form, this preemptive measure should not pose any storage problems.
In conclusion, please be mindful your tax return speaks volumes, and the IRS is “listening.” And that’s OK. Just be honest and preemptive, so that you’ve done your part.
In an upcoming article, I intend to point out some helpful strategies to deploy if one were to receive the dreaded IRS audit notice.
Michael Cohen, CFE, CPA was an IRS auditor for 10 years. He then served as an IRS special agent conducting criminal tax and money-laundering investigations for 20 years. Cohen currently practices in academia and as a forensic accountant specializing in such areas as fraud detection, business disputes, divorce asset-tracing, estate asset-tracing and IRS tax resolution. He may be reached at [email protected] or at [email protected].