An income tax audit can occur to both individuals and businesses in the United States. Audits may be referred to as examinations, reviews, and notices. Audits are mostly conducted by the Internal Revenue Service (IRS), but may also be conducted by local state tax authorities. During an audit, the IRS or other organization examines the party’s tax return in order to ensure that it has been filed accurately and does not violate tax codes in the United States.

Statistics

The number of federal and state audits fluctuates from year to year, although it has been increasing in recent years. In 2011, a survey of nearly 900 corporate tax executives indicated that both federal- and state-level tax disputes had increased since 2010. The majority of respondents indicated that they believed that auditing activity would continue to increase at both levels for corporations. Data from the Treasury Inspector General for Tax Administration also indicated that corporate audits had increased by approximately 5% between 2010 and 2011. The goal of this additional activity is to compensate for budget shortfalls by increasing revenue from corporate taxes. Revenue from corporate tax enforcement measures increased by 18% in the 2010 fiscal year, resulting in an additional $57.6 billion. The ever-increasing likelihood of being audited for companies is a reminder to take care in filing their annual taxes every year.

Selection Methods

Most people and businesses will undergo a tax audit at some point. They may be selected by one of a variety of methods used by tax examination groups. The following are the methods used by the IRS:

  • Third party documentation: refers to forms that both employers and financial institutions are required to send to the IRS, such as 1099’s and W-2’s. The IRS employs software to ensure that third party documents match the numbers on a company or individual’s tax return. If they do not, it may result in an audit.
  • Discriminant Index Function System (DIF) Score: A DIF score is a figure generated by a computer program that analyzes tax data for discrepancies and abnormalities. If the DIF score is past a certain mark, the tax return may be selected for further examination.
  • Unreported Income Discriminant Function System (UIDIF): Tax returns are also run through statistical software that assesses the tax return’s likelihood of income that has not been reported. Returns that are have a high potential for undeclared income are flagged.
  • Random selection: is used to select a certain number of tax returns for review each year. A tax return does not have to have any recognizable errors to be chosen for further examination. Random selection ensures that even those tax returns that don’t show any potential errors or discrepancies are reviewed. This technique has come under fire as intrusive and time-consuming for the auditors. The practice was suspended but reinstated by the IRS in 2006.

Quick Summary

A tax audit occurs when one of either the IRS or the state tax authority decide to examine a tax return in further detail. The number of corporate audits has increased in recent years as the additional revenue is used to make up for budget shortfalls. There are a variety of reasons why a tax return might be flagged for further examination. Each year, a certain number of returns are selected at random.