Income tax audit


In the United States of America, an income tax audit is the examination of a business or individual tax return by the Internal Revenue Service or state tax authority. The IRS and various state revenue departments use the terms audit, examination, review, and notice to describe various aspects of enforcement and administration of the tax laws.

Purpose

The purpose of a tax audit or a return examination is to determine whether reports filed with the taxing authorities are correct. The tax agencies identify and resolve taxpayer errors.

Selection methods

There are several different methods used to select individuals and businesses for examination.

Third party documentation

Employers and financial institutions, among other organizations, are required by law to send documentation to the IRS. The IRS uses software to ensure that the numbers on a tax return match the numbers the IRS receives from third parties. If the documentation does not match, the return may be examined.

DIF score

When a tax return is filed, the IRS uses computer software called the Discriminant Index Function System to analyze the return for oddities and discrepancies. Once the return has been processed through DIF, it is given a score. If the DIF score is high enough, that tax return may be selected for examination. The formulas the IRS use to create the DIF software and analysis are a closely guarded secret.

UIDIF score

Filed tax returns are also subjected to an evaluation called the UIDIF, or the Unreported Income Discriminant Index Function System. This evaluation involves the analysis of tax returns based on a series of factors to determine a tax return's potential for unreported income. Returns that are found to have a high UIDIF score and a high DIF score may be selected for examination. The IRS formulas used to calculated UDIF are secret, but it is commonly thought that the IRS uses statistical comparisons between returns to determine UIDIF potential.

Random selection

The IRS selects a certain number of income tax returns to be audited each year through random selection. No errors need to be found for the Enforcement branch to examine a tax return. Random selection exams tend to be more extensive and time-consuming than other forms of review.

Controversy

The practice of random selection has been a source of controversy for many years. The practice was suspended for a short time in the early 2000s amid criticism that the audits were too burdensome and intrusive. The IRS revived the practice in the fall of 2006.
In April 2019, Propublica reported that IRS audit selection methodology, with its emphasis on Earned Income Tax Credit claimants, resulted in a higher audit rate of low-income African-American in U.S. counties located in the Southern states, Hispanic taxpayers in counties along the Texas-Mexico border, and certain counties with a high percentage of Native Americans.

Taxpayer rights & tax audit representation

When a return is selected for examination, the taxpayer has certain rights during the process.

Taxpayer rights

Each state will have its own version with respect to state taxes. With respect to U.S. federal income taxation, the taxpayer has the following rights:
A taxpayer is required only to submit the auditor information relating to the specific year listed in the audit notice.

Tax audit representation

, also called audit defense, occurs when a tax or legal professional stands in on behalf of a taxpayer during an examination. Federal law and all states allow a taxpayer to have an authorized representative. The representative must have permission to practice before the IRS or state, and specific credentials are required. The types of representatives who are allowed to represent taxpayers before the IRS in income tax audits include attorneys, certified public accountants, and enrolled agents.