For most taxpayers, whether businesses or individuals, the chances of an examination are about 1%. For a taxpayer earning over $1,000,000 per year, the odds exceed 8%. The odds of examination can increase dramatically because of the information reported on or omitted from returns.
For example, one way the IRS selects returns for examination is by assigning a Discriminating Function System Score (DIF Score). Taxpayers receive higher DIF scores and are more likely to get examined when they: 1) report high incomes, 2) are self employed, 3) fail to file necessary schedules/forms, 4) receive large refunds, 5) deduct casualty losses, 6) claim tax credits, 7) report foreign bank accounts, 8) fail to report income reported to the IRS by third parties on information returns or 9) earn a higher income and report losses from rental property. In fact, earning a substantial income alone can increase a taxpayer’s odds of examination by more than 750%.
The IRS also considers currency transaction reports (a report of a cash deposit of more than $10,000), document mismatches, information from informants and referrals from other federal agencies when selecting returns for examination.
The IRS reports annually on its examination of returns in Publication 55B, the Internal Revenue Service Data Book. During the 2010 fiscal year, the IRS examined 1,735,083 returns, 0.9% of the 187,124,450 returns filed during the 2009 calendar year. Individual income tax returns made up more than 91% of the returns selected for examination, and the rate of audit of those returns exceeded 1%. The IRS also examined 28,733 partnership and S corporation returns and 29,903 C corporation returns. High-income taxpayers were examined much more frequently than other taxpayers.
The IRS categorizes individual income tax returns as follows: returns with total positive income under $200,000, returns with total positive income of at least $200,000 and under $1,000,000, returns with total positive income of $1,000,000 or more and international returns. Individual income tax returns with total positive income of $1,000,000 or more, i.e. high-income individuals, were the most likely to be examined with 8.4% of the returns filed being selected. Business owners with gross receipts of $100,000 – $199,999 came in second with 4.7%. IRS studies of the tax gap have shown that although over 98% of wage earners report their income, the compliance rate among the self-employed is much lower. Therefore, the IRS seeks to exam more schedule C returns.
The IRS’s motivation for examining higher income individuals is very clear: examinations of high-income individuals result in more tax being assessed for the same amount of work. In 2010, the IRS examined more than 275,000 business returns without Earned Income Tax Credits. The average recommended change for those returns was between $2,619 and $31,979. Comparatively, the average change for high-income individuals was between $151,874 and $163,520. Since the labor involved in examining the two types of returns is relatively similar, the IRS elects to audit high-income individuals where it is likely to assess more tax. The IRS’s examinations of high-income taxpayers, who account for only .017% of the filed returns, resulted in a total proposed increase in tax of $2,613,872,000 in 2010, more than 31% of the total proposed change for all returns.
Interestingly, high-income tax returns are also among the least likely to contain errors. In 2010, the IRS examined 32,494 returns from high-income individuals. Of that total, 25% of the returns examined in the field and 34% of the returns examined by correspondence were not changed. Comparatively, the examination of some business returns resulted in changes more than 90% of the time.
C corporations are under similar scrutiny to individual taxpayers. While C corporations have an overall examination rate of 1.4%, more than 16% of the C corporations with assets in excess of $10,000,000 were examined in 2010. The examination rate increases dramatically as assets increase and is 98% for the largest C corporations.
S corporations and partnerships are some of the least likely taxpayers to be examined, with only .4% of the returns filed being selected. But, pass through entities are often subject to de facto examinations when their shareholders and/or partners are examined.
Like a business, the IRS looks for the biggest return on its investment of time. Considering that a revenue agent could complete as many as 60 small business examinations to match the tax increase from the examination of a single, high-income individual, there is little mystery to the IRS selection process.
Robert E. McKenzie, J.D., is a partner at Arnstein & Lehr, LLP in Chicago, IL, and is co-author of Representing the Audited Taxpayer Before the IRS. Robert A. McKenzie, J.D., is an associate at Arnstein & Lehr, LLP.
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