99.9% of IRS audits happen for 1 of the following 4 reasons: Information reported by others about you, Your historical information, Tons of ‘peer data’, and the Information you are submitting in your current year tax return.
IRS audit returns based on what they know about you – and how do they know about you? They know about you because others (employers, banks) report information about you to the IRS, they know about you because you have submitted tax returns in the past, they ‘know’ what your ‘peers’ report on their income tax returns, and lastly they know about you because of what you are submitting now (current year tax returns).
Let us take these 4 categories of information one by one:
Category 1: Others report information to the IRS
Others like your employer or the bank will report information about you to the IRS. These others fall broadly into two categories – either they are telling IRS that they have given you money that should be included in your income OR they are telling IRS that you have given them money and you might be allowed to deduct it.
A simple example of the one where they are saying they have given you money that should be included in your income is your employer. Your employer issues you a W-2 because you were paid wages. The employer reports this information to the IRS too and the IRS is expecting the numbers to match on your tax return. If it does not match, then the result is an IRS audit.
Here is an example to show you how easy it is to forget an income source, specially if it is small as compared to your overall income: Someone known to me had more than $32,000 in business income and forgot to add $79 that she earned through renting the extra room in her house.
When I start thinking about my taxes for the year, the first thing I do is prepare a list of all the sources of income (W-2, 1099-MISC, 1099-K, 1099-INT, Schedule C etc).
A simple example of the second kind of ‘others’ – where they report information because you have given them money that you might be allowed to deduct is the bank with whom you have a mortgage. You pay mortgage interest through out the year, and the bank will issue you a Form 1098 at year end to tell you how much interest have you paid. The bank submits this information to the IRS too. And if your tax return does not match IRS information, you know what happens – IRS audit.
Category 2: Your past tax returns
The second way IRS know about you – because you because you have submitted tax returns in the past. I can probably think of a couple of hundred ways in which this can play but let us take a couple of examples to begin with:
Example 1: You claimed 30% tax credit for installing a geothermal heat pump on your primary residence in 2014. In 2015, you again claim a tax credit for installing a geothermal heat pump. While IRS computers might not understand the internal thermodynamics of a geothermal heat pump, they are likely to understand that this is not something that a taxpayer does every year (specially on the same property).
Example 2: This actually happened to someone I know. They lived in California (silicon valley), where the state taxes are one of the highest in the country. Husband was involved in a successful start-up where he worked several years. Then the start up was to be taken over by a big computer giant. This meant multi – million dollars payout for the husband.
The family moved to Florida. There are no state taxes in Florida. The big payout happened, the family was happy. Next year, the family moved back to California. And guess what? They were audited at the state level. The state (in this case California) notices anomalies – you make ‘x’ and live in CA for several years. And then in between, there was only one year when you made ’20x’ and you ‘lived’ in a state that does not have income tax, ahan tax audit!
Category 3: IRS knows ‘what your ‘peers’ report
About 70 million people file tax returns every year so it is no surprise that IRS knows at least a few million in your age group, in your profession, in your income bracket, in your income tax bracket, in your state, in your ‘any attribute’.
Let us take charitable contributions for example. IRS knows how much your average ‘peer’ (who makes the same amount of money as you do) contributes. If you contribute way more than that, then the chances of an IRS audit increase tremendously.
For self employed people (people who file schedule C), the most important attribute is the “Principal Business Activity Code”. This code is based on the North American Industry Classification System (commonly known as NAICS). Simply put, this code tells the IRS industry (classification) your business falls into. And once, IRS knows the domain where your business falls, it immediately knows
In 2013, about 25 Million Schedule C were filed. There are about 400 NAICS codes. Not all codes are equally prevalent, but just to get a rough idea, let us assume that all the 25 Million Schedule C were distributed equally among the 400 NAICS codes. We are talking about 25 million/ 400 codes = 62,500 Schedule C for every code.
So for your Schedule C (in a particular industry), IRS has 62,499 other Schedule C’s to compare and see what is the ‘standard’ in your industry. If the ‘industry standard’ says that COGS (Cost Of Goods Sold) is 24% and your Schedule C says COGS was 57%, no prizes for guessing that chances of an IRS audit increase.
As soon as you specify your NAICS code, the IRS knows how high (or low) your business expenses are likely to be. For a heavy industrial manufacturing plant, the depreciation costs of PPE (Plant Property Equipment) are likely to be higher (in percentage terms) as compared to attorney’s office – who primarily deducts depreciation on office furniture, laptop, cellphone, and the car.
Similarly, it is natural for the IRS to suspect you if your primary activity code suggests that you are a janitor (code 561720) but you deduct overnight business travel costs that is 15% of your business revenue.
You can read more about NAICS codes on the Bureau of Labor Statistics website (bls.gov), it has an interesting collection of statistics.
Category 4 – Current year return data
Lastly, IRS audits you simply based on your current year tax return data. Most common are disconnect in what you say and what others say about you (similar to category one), illegible handwriting (for people who still fill the forms by hand), mathematical errors (calculation mistakes), and the use of ‘statistically rare’ numbers.
All others are obvious but I would like to elaborate a little bit more on what are ‘statistically rare’ numbers. Let us say you bought a printer for your business, what are the chances that the printer costed exactly $300.00 (including shipping and taxes). $300.00 is such a neatly rounded number that it is difficult to believe. It is more likely that the person just has put in a rough estimate he (or she) remembers OR even worse, did not even buy a printer but is claiming a deduction.
On the face of it, this looks such an obvious mistake that taxpayers should not be making, but you will be surprised as to how common it is (and not only by low to middle income taxpayers, even by people making a lot of money).
Now time for some examples – here is one where someone claims 100 miles per day travel deduction… 100 miles, neither 98 nor 102, but exactly 100 miles. The tax court judge notes “round numbers indicate that these figures are themselves only estimates”.
My personal favorite though is the case of Basement Doctor, Inc. – the business that reported losses of exactly $100,000 not only once but twice…. in consecutive years (1999 and 2000). The judge noted “Such round numbers cast additional doubt”.
Talk about probability and statistics – for a business making a loss of $1 to $100,000, the probability of it making a loss of $100,000 is 0.001%. And the probability of the same business making a loss again of exactly $100,000 is 0.001% * 0.001% = 0.00000001% – that is what I call statistically rare. Sure shot chance of an IRS audit.
To give you an estimate of how small 0.00000001% is – pick a person at random from Unites States, the chances of him being the President of the country are 33 times higher than 0.00000001%. Now you tell me shouldn’t all these smart CPAs and attorneys have seen the IRS audit coming?.
Why is this my personal favorite? Because even guys like these (or their CPAs and attorneys) whose net worth is several million dollars and who perhaps spend tens of thousands of dollars every year on tax planning; still end up making such silly mistakes.
Moral of the story: Avoid nice looking round whole numbers
I will give one last example of Category 4: how solely the information on the current year tax return can lead to IRS audit. Let us say you have a small business and you have a car that you use for your business. What are the chances that you use the car only for business and never ever for anything else? It’s almost impossible to believe that you never use the car to pick up your father from the airport, or use the car to go for movies, or take a detour (on a business trip) to pick up groceries, or for any other personal purposes.
Moral of the story: It is statistically rare that you use the car for 100% business purposes.
Even if you are audited, then also there is nothing to worry (provided you haven’t wronged).
Tax code is complex and IRS practitioners realize that. In fact, there was this one time, I was sent a notice from one of the states (Ohio) where I had some earned income. I was surprised. I called up but was not satisfied with the answer the person over the phone gave me. He just went on to read the notice again and again, without being able to explain to me how the state calculated the dollar amounts. After nearly half an hour, I just gave up.
I called up again, this time I found someone who listened to my logic and said “Oh yeah, I do not see how we calculated a different number”, then both of us spent a good 45 minutes to put together our brains, she asked people around her, I opened up my tax code journals. Finally, we learned that our logic was incorrect. And then all I had to do was send them a check for the additional tax they were asking for and the mater was over.
So having a tax audit is no big deal in many cases unless you have done something seriously wrong; but even then one would rather avoid it – the stress and paperwork just isn’t worth it for law abiding citizens. Keep the 4 categories I mentioned in mind, and you will be just fine.