Playing “Audit Roulette” with the IRS

“So, what are the chances the IRS is going to audit me?”  It is common for many clients to make this inquiry when in the middle of a discussion related to the defensibility of a subjective tax position.  As any competent CPA knows, considering the probability of an audit examination when determining the appropriateness of claiming a tax deduction should never be part of the equation when giving tax advice.  If tax law does not support a reporting position being considered, then the reporting position should not be taken regardless of the probability of triggering an audit by the IRS.  Taxpayers and their advocates that use such reasoning when determining tax reporting positions are playing “audit roulette,” a game they will ultimately regret playing.

No one wants to endure an IRS audit, even if their tax returns are complete, accurate, and are fully supported by proper accounting records and supporting documentation, but there is always a chance of being selected for audit.  The number of returns selected for audit is approximately 1-3% of all returns filed in a particular year though the possibility of being selected increases for individuals and businesses with higher income levels.  Informal discussion among the CPA’s in our office revealed anecdotal evidence that most clients with revenues in excess of $10,000,000 had been examined at least once within the last ten years.  Additionally, it appears that the frequency of the audits has increased substantially over the last few years.

Many audits conclude relatively quickly as they are limited in scope to a certain type of revenue or deduction such as meals and entertainment on a business return or charitable contributions on an individual return.  However, an audit may exceed one year in duration if the scope is not limited or increases after origination and the entire return and all supporting documentation is under audit.  Such audits may still result in little or no change to the tax owed, but the cost and disruption caused by such a lengthy audit can be substantial.

How does the IRS determine which returns to audit and what the scope of those audits will be?  Some returns are selected at random using statistical programs, but most are selected by the IRS due to “red flag” issues that the IRS has identified, including:

• The taxpayer owns an equity interest in another entity selected for audit
• The taxpayer has conducted significant transactions with another entity selected for audit
• The tax return reports revenues or expenses that do not match other documentation obtained by the IRS
• Certain income types or deductions on the return are not consistent with other factors the IRS has considered with respect to other facts and circumstances of the taxpayer

Most audits result from an item or items on the tax return not matching various documents received by the IRS.  When the IRS receives such things as Forms W-2’s, 1099’s, K-1’s and some other required documentation, they try to match such items to the taxpayer’s return. For example, if an individual taxpayer receives a Form K-1 with royalty income, but erroneously reports such income on Schedule C versus Schedule E, the IRS will be searching Schedule E for the reporting of the royalty income.  When the income is not found on Schedule E, an IRS audit or at a minimum, an IRS letter inquiry will follow.  The IRS is able to do the same basic procedure on business returns by comparing revenues and deductions on Forms 1065 or 1120 to documentation such as payroll tax filings, year end W-2 and 1099 reporting, and credit card revenues reported by  third parties. 

Fortunately, because most audits are initiated through the matching documents method, a substantial majority of potential audits can be avoided with a properly prepared tax return.  By knowing which forms and form lines to use when reporting income and deductions, the tax return will be prepared correctly and the most common type of audit trigger is virtually eliminated.

At Melton & Melton, we attempt to prepare every return in a manner that minimizes the chance of the IRS selecting it for audit while still providing the maximum deductions and minimum tax due using positions supportable by tax law.  Attention to detail in the preparation of returns is far more effective over the long term in helping clients to avoid the cost and stress of an IRS audit than playing and eventually losing the “audit roulette” game.