Tax audit chances revisited: the role of document matching

This is a follow up to our April 3 post on how tax audit chances increase with income. We noted there that while the overall IRS audit rate is only about one percent, it rises rapidly the higher a taxpayer’s income gets.

But how does the IRS which upper-income returns to review more closely than others? For taxpayers in Texas and across the country, the answer can mean the difference between undergoing a difficult IRS tax audit and avoiding one altogether.

No one knows exactly how the IRS decides which returns get extra scrutiny. Like Google’s vaunted algorithm, the equation that assigns scores to certain types of activities is not public knowledge.

But we do know what the scoring system used by IRS computers is called. The system is called the Discriminant Inventory Function system, or DIF for short.

Based on past experience, it is also possible to make some educated extrapolations about how the IRS approaches audits. For example, the IRS has a well known interest in business owners, as well as taxpayers who report capital gains on Schedule D.

Keep in mind, too, that IRS computers are sophisticated enough to perform a function known as document matching. This technique enables the IRS to compare data from a tax return with comparable information from other sources.

This information could come from employers, financial services firms or some other source. For example, let’s say you received a big dividend from a very successful stock. Document matching could enable the IRS to detect a failure to report this as income on your tax return.

In short, the IRS uses various methods to flag potential discrepancies in a tax return. But even if there are no apparent discrepancies, there is still a random element involved that could result in an audit nonetheless.

Source: The Wall Street Journal, “Chances of an Audit Grow With Income,” Tom Henman, May 12, 2003