How to know if the IRS will audit you

Every year, I get into a conversation with someone about the home office deduction. It's one of the many deductions steeped in mystery and fear.

As may not be a surprise for many of you, I work from home. In our home, we have a dedicated office that is used for nothing else. OK, one exception — when our daughter comes in the morning with an armful of stuffed animals and books… for fifteen minutes each day I read the same book over and over again (everyone say awwwww!).

That home office deduction is always one that worries other self-employed folks because it's known as a “red flag” since it's so easy to abuse. Pick a spot in your house, claim it as an office, and offset some of your income. If you get audited (the IRS calls it an “examination,” so cute), show it's regular and exclusive by making it look regular and exclusive. Then show it's your principal place of business, which is easy since you have no other place of business. Boom. Done.

I've never been audited for the home office but I'm not worried, because it is a home office. And now with the simplified option, which is essentially $5 per square foot, there's a near zero chance I will be.

You know what I have been audited for? I've gotten a couple CP2000 clarification letters. They're just automated letters that ask you to explain a computer discovered discrepancy in your tax return. All the forms you received in the mail were also filed with the IRS. One year I forgot a 1099-INT (paid a little extra tax) and the next year I reported a 1099 as a business income item instead of a personal item (paid no extra tax).

The IRS doesn't audit for no reason. They audit when they believe they can make money (collect a recommended additional tax assessment) and make a lot of it.

It's really unlikely they will examine your return. In the 2014 tax year, the latest information they have, only 0.7% of tax returns were examined. 0.3% for those with less than $200,000 income and without the EITC. The number goes to 2.2% for income between $200k and $1mm. (IRS stats)

One of the biggest targets for them are self-employed taxpayers (business returns w/o EITC), they audit about 1.5% of them annually, because self-employed folks are shady.

Oh yeah, and millionaire earners… 7.5% of those folks got examined too. They're shady too. 🙂

How the IRS Picks Who to Audit

There are a lot of tax returns, so the IRS turns to computer. This meaty paper titled “Comparing Scoring Systems From Cluster Analysis
and Discriminant Analysis Using Random Samples” by William Wong and Chih-Chin Ho explains the methodology. The gist is quite simple – calculate a scoring formula for each tax return and compare it with a stratified random audit sample that gets refreshed periodically.

This IRS page has less statistical explanation:

1. Computer Scoring – “Some returns are selected for examination on the basis of computer scoring. Computer programs give each return numeric “scores”. The Discriminant Function System (DIF) score rates the potential for change, based on past IRS experience with similar returns. The Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income. IRS personnel screen the highest-scoring returns, selecting some for audit and identifying the items on these returns that are most likely to need review.”
2. Information Matching – Like my CP2000 notices, if certain numbers don't match then the IRS will request clarification.
3. Related Examinations – If your tax return is related to another that they audited, you may be audited too. For example, if you are business partners with someone and their return is examined, it may affect yours since some of their numbers may change. This will prompt a look at your return.
4. Potential participating in an abusive tax avoidance scheme – It's a meaty category name but it's similar to the Related Examinations reason. If, for example, your CPA is examined for an abusive tax avoidance scheme, your return may be reviewed since the CPA prepared your return as well.

What's a Audit-Fearing Taxpayer to do?

#3 Related Examinations and #4 Potential Participation in a Tax Avoidance scheme are out of your hands. If your CPA seems shady, find a new CPA.

#2 Information Matching is just an issue of doing your taxes correctly. Go with software, it's usually free, and it's so good nowadays. Most quick tax places you go to these days are just people sitting in front of software… do you really need to pay for that?

The big concern then is #1 – Computer Scoring. When I read the statistics paper by Wong and Ho, the basic idea was that the software was looking for outliers. If you earn $5,000,000 and pay $0 in taxes, that's something that warrants another look.

Here's the thing — abusers will abuse and eventually will get caught. Then their past returns will be examined. If you have documentation, you're safe.

Will you get audited if you claim a home office? Probably not.

Will you get audited if you claim a bunch of cash donations to charitable organizations just under the limit requiring paperwork? Probably not.

Will you get audited if you claim all the gray area deductions? Also probably not.

If you claim the ones you're entitled to, like a home office, you'll be fine even if you claim them all.

Don't let the fear of an algorithm prevent you from claiming what's rightfully yours.

(and if you are fearful, free audit defense can help you sleep at night)

It's the taxpayers who don't have paperwork and are egregious about it… they are the ones who will get audited and penalized because the computer will catch it.

Just to double check, I did what any nerd would do, I started reading these reports. Well, scanning. I skipped a lot of it, honing in on Most Litigated Issues. Unfortunately, the categories are very broad and not particularly useful for an individual taxpayer. There's a lot for small business owners and fall into the category of allowable expenses. Home office was litigated once for an individual and 10 times for a business. Substantiating an expense came up 14 times for individuals and SIXTY times for business – it's really about the other expenses.

I did learn that if you do go to court, don't represent yourself? Pro Se Taxpayers (self-represented) only prevailed 19% of the time while represented taxpayers prevailed 28% of the time. (correlation is not causation… maybe the self-represented knew they were dead meat so they wanted to save money going solo?)

I also discovered another little gem, something I didn't know (I'm not a tax expert) – the Cohan Rule.

The Cohan rule is one of “indulgence” established in 1930 by the Court of Appeals for the Second Circuit in Cohan v. Commissioner. The court held that the taxpayer’s business expense deductions were not adequately substantiated, but stated that ”the Board should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making. But to allow nothing at all appears to us inconsistent with saying that something was spent.”

There are exceptions to the rule, like for travel, but it's otherwise useful, I suppose, for business folks who buy something and manage to have zero record of it in our electronic age. 🙂