Chances of an Audit Grow With Income

Tom Herman for the Wall St Journal writes: What are the chances that the Internal Revenue Service will audit your income-tax return?  At first glance, the answer appears simple: very low. The IRS has audited only about 1% of all individual income-tax returns in each of the past several years.

But these numbers can be highly misleading. As with so many tax questions, the real answer is: It depends.

The IRS uses a multipronged approach in selecting its victims. For example, IRS statistics clearly show a special interest in upper-income taxpayers. Last year, the IRS audited nearly 4% of those making between $500,000 and $1 million. It audited nearly 9% of those making $1 million to $5 million. For those making $5 million to $10 million, the audit rate was 18%. For those who made $10 million or more, the audit rate was more than 27%.

IRS officials are keenly interested in taxpayers who own their own businesses, file what is known as "Schedule D," and deal in large amounts of cash.

To help in the selection process, the IRS assigns a score to each return based on a secret formula designed to pick those returns where "the potential is high that an examination of your return will result in a change to your income tax liability." Its computer program is known as the "Discriminant Inventory Function" system, or DIF.

Then there is "document matching." The IRS matches what taxpayers have reported on their returns against what was reported separately to the government by employers, investment firms and other sources. If there is a mismatch, be prepared to explain the difference.

Some people are selected because of tips the IRS has received from would-be informants. Or perhaps you were unlucky enough to have your return selected at random.

If you do get audited, don't panic. Most IRS inquiries are "correspondence" audits that raise questions by mail about specific items on your return. You may be able to handle routine items easily by return mail.

Keep detailed records to support everything on your return. While you don't want to turn into a hoarder, err on the side of saving tax-related records just in case your return gets picked.

If you want to attract attention to your return, try making what IRS officials refer to as "frivolous" arguments—such as claiming you don't owe anything because there is no law requiring anyone to pay income taxes, or that wages somehow aren't taxable.