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Financial
May 15, 2017

Why Did I Get Audited By The IRS?

Sponsored Content provided by Adam Shay - Managing Partner, Adam Shay CPA, PLLC

This Insights article was contributed by Richard Pasquantonio, CPA/CFF, CFE, CDFA (NC License Number 33577), an associate at Adam Shay CPA, PLLC.

IRS examinations and appeals are part of an overall system of federal tax liability determination that includes a lot of players. It begins with the voluntary actions of the taxpayer reporting information to the IRS, but from there it can include: the U.S. Tax Court; the Tax Division of the Department of Justice; the Joint Committee on Taxation; federal district courts and the U.S. Court of Federal Claims; federal courts of appeal; and the U.S. Supreme Court.

Once a taxpayer has filed his or her income tax return, the IRS processes the return at an IRS campus, where it applies computational and other information checks to determine if any further examination of the return is required.
In most cases, the taxpayer's voluntary self-assessment of his or her tax liability is accepted by the IRS and becomes the final tax liability determination.

The processing of returns has become increasingly automated over the past decades under the IRS’s Automated Data Processing (ADP) system, which originated during the 1950s and has grown exponentially until today, when the IRS depends on a largely automated system to process returns. In addition, AIMS, the Audit Information Management System, is a complimentary computer system used by the IRS Examination and Appeals divisions to control returns, input assessments and adjustments to returns, and reports to IRS managers.

The IRS operates several types of automated programs for processing returns. The Automated Underreporter Program (AUR) matches information documents received from third parties - such as W-2 Forms and 1099s that report interest and dividends - against tax returns and identifies where there is a mismatch. The AUR then sends out computer-generated letters, called CP2000s, to taxpayers notifying them that the IRS will assess additional tax unless the taxpayer comes forward with information demonstrating that the additional tax is not in fact due. 

Another example is the Automated Substitute for Return (ASFR) program. The ASFR operates when the computerized document matching programs cannot find a taxpayer return to match with third-party information returns received. As a result, the ASFR then sends out computer-generated notices called the Letter 2566 – Notice of Proposed Individual Tax Assessment. The Substitute for Return (SFR) is a proposed assessment based solely on the information received from the third parties, such as employers, banks and brokerage houses.

In addition, the Automated Correspondence Exam (ACE) program addresses a wide array of issues identified by the computerized processing of returns and result in computer-generated notices to taxpayers with little or no involvement by IRS personnel until a reply is received from the taxpayer.

According to Bloomberg Bureau of National Affairs:

the top complaint by the National Taxpayer Advocate in the annual report to Congress, released January 11, 2012, was lack of funding and the negative effects of automation. The National Taxpayer Advocate stated that the IRS has devoted more and more of its reduced budget (2.5% cuts in both fiscal 2011 and fiscal 2012) to automation in an attempt to cope with an ever-growing workload with fewer resources, and warned that, while some practitioners may expect their client base — the wealthiest 1% of the population — to be immune from continuing IRS cuts, they will most likely suffer the effects of increased automation.

Once returns are selected for examination, the examination may be conducted as a computer-generated correspondence examination discussed above, from one of the IRS campuses, or, in more complex cases, by the Examination Division at the area-office level.

According to the Internal Revenue Manual, the primary objective of the IRS in identifying and selecting returns for examination is to try to promote the highest degree of voluntary compliance. The IRS recognizes that it can examine only a small percentage of the returns filed and should aim to audit those returns most likely to have errors. The various automated methods are used to identify errors in order to select returns for examination, with the most common method being using Discriminant Function (DIF) formulas.

The DIF system is a mathematical technique used to score income tax returns according to their examination potential. Mathematical formulas are developed and programmed into the IRS computers to identify returns by assigning weights to certain basic return characteristics. The weights are then added together to produce a score for each return. The current DIF formulas were developed based on a compliance study performed by the IRS, dubbed the National Research Program. Generally, the higher the DIF score, the greater the audit potential. The highest scored returns are made available to the IRS Examination Division upon request. The DIF mathematical formulas are confidential and for official use only. The DIF score assigned to a return is not disclosed.

In addition to the computer-generated methods outlined above, the IRS also uses information from outside sources that indicate that a return may have incorrect amounts, according to IRS Publication 556, Examination of Returns, Appeal Rights and Claims for Refund. These sources may include newspapers, public records and individuals. If the IRS determines that information from these sources is accurate and reliable, it may use the information to select a return for examination.

As you can see, the overwhelming majority of IRS audits are initiated automatically because of computer processed returns and computer-generated correspondence, including notices and letters.  According to the National Taxpayer Advocate, because of the IRS’s increased dependency on technology, there has been a significant increase in notices sent to taxpayers. From 2001 to 2009, notice volume increased 670 percent, or from 30 million notices sent in 2001 to 201 million notices sent in 2009. During that same timeframe, the IRS has only seen a 10 percent increase in taxpayers.

Richard Pasquantonio, CPA/CFF, CFE, CDFA (NC License Number 33577), is an associate at Adam Shay CPA, PLLC. He focuses on forensic accounting, fraud prevention and detection, and tax controversy resolution. He is also an AICPA CFF Champion. The purpose of the CFF Champion program is to inform the professional community about the vital role of forensic accounting professionals, the knowledge required to become a CFF, and the benefits of the CFF credential. For more information, visit http://www.wilmingtontaxesandaccounting.com/ or email him at [email protected]. Pasquantonio can also be reached by phone at (910) 256-3456.

Adam Shay, CPA (N.C. License Number 35961), MBA, is managing partner of Adam Shay CPA, PLLC. He focuses on minimizing taxes and improving the financial results of entrepreneurs, and is actively involved in supporting the Wilmington entrepreneurial and startup community. For more information, visit http://www.wilmingtontaxesandaccounting.com/ or email him at [email protected]. He can also be reached by phone at (910) 256-3456.
 

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