This time of year millions of Americans prepare their income taxes, sign the E-file forms, and then transmit their financial information to the IRS. Where does the information go? What does the IRS do with it? How does this impact the chances of an audit or notice being generated by the IRS? These are all questions that few people think about, but they represent the real inner workings of our tax system.
To many the IRS E-file system feels like a void where tax information goes and is never seen again. In many cases this is not too far from the truth. Most tax returns are never reviewed by an actual person. However, there are three major exceptions which are part of the IRS audit and review functions that are designed to keep American Taxpayers honest and collect the tax that is due under the tax laws.
When a tax return is transmitted to the IRS it goes into the IRS computers which analyze the data. The computer serves two major functions. The first is that the computer cross-references the information reported on the tax return with information provided by employers, investment firms, mortgage companies, etc. If the tax return is missing income that was reported as paid to the taxpayer by another party the computer will often generate a tax notice. These notices list the discrepancy and request that the taxpayer either pay the tax that would be due or explain the discrepancy with supporting documents.
The second role of the IRS computers it to assign the tax return a score based on a statistical analysis of the income and deductions claimed on the return. If the return is assigned a high enough score it goes into a pool of returns that are flagged for potential audit. IRS auditors randomly pull returns from this subset of tax returns to review. If the auditor agrees with the computer’s assessment they may initiate an audit.
The IRS computer also flags tax returns for random audits. Random audits are not based on the income or deductions that are listed on the return. Instead, they are influenced by the level of income reported on the return. Naturally, the IRS knows that they are more likely to collect additional tax from high income taxpayers who are in high tax brackets. Therefore, they prioritize those returns. Some of the highest income taxpayers and business returns are audited every year automatically due to the complexity of the returns and the fact that even relatively small changes to income or deductions can yield a large amount of additional tax collections.
The last major source of IRS review is the audits that are conducted for statistical purposes. These are often the most comprehensive reviews of tax returns are the IRS is generally not looking for anything in particular. Instead the goal is to review all of the information on the return to ensure its accuracy. The information from these audits are then used to build the statistical models that the computer uses to score returns and determine if they should be feed into the audit pool or allowed to linger in the void of the IRS databases.
Given the IRS audit and review procedures there is always a chance that a taxpayer’s return will be audited or reviewed each year with the likelihood increasing with the level of the taxpayer’s income. However, there are things that taxpayers can do to reduce the stress of dealing with the IRS. The first is to make sure that all income is reported on the return. That way the IRS computer will not issue a notice based on a discrepancy between what is reported by the taxpayer and third party reporters. Second, taxpayers should avoid taking aggressive positions on their tax return unless they are confident that the position is correct and it can be substantiated. Finally, it is important to keep all of the supporting documents that are used to file a return. That way the taxpayer will be prepared if they are audited or receive an IRS notice. This can help to reduce the stress level of an IRS audit or receiving an IRS notice.