The audit rate for individuals normally hovers around 1%. Numerous factors contribute to that figure making for an interesting discussion. As F.J. Raymond aptly put it, “Next to being shot at and missed, nothing is quite as satisfying as an income tax refund.”
Traditional in-person audits have historically looked something like this:
There seems to be an inverse relationship between the audit rate and the state of the economy, with audits increasing after each significant market downturn. (i.e., 9/11 or the crash of "08.) The Covid pandemic was the exception because the IRS became a conduit for issuing stimulus money instead of collecting taxes. Now that it's past, we see the audit rate returning to it's normal levels. Some argue that the rate fluctuates depending on which political party is in power but all conspiracies aside, there is little doubt that politics plays a role. When the government needs revenue, ramping up tax collections is a viable way to raise funds.
For every dollar congress allocates to the IRS, they generate approximately $2,000 in tax revenue. Despite how we feel as taxpayers, this is a testament to the efficiency of the IRS. Thirty years ago, they had over 110,000 employees; today they accomplish the same job with less than 80,000. We often assume that the IRS is using the latest technology to track our every move, but the reality is quite the opposite. Even with antiquated systems the things they accomplish using advanced mathematics and statistics are nothing short of impressive.
A basic in-person audit costs the IRS around $1,000 and they have discovered that random audits are not the most efficient use of these resources. Instead, each summer, after a majority of taxpayers have filed their returns, the IRS assigns a DIF (Discriminant Income Function) score or risk factor to each return. They use these scores to determine which returns to audit and how much additional revenue they can expect from each one. Modern audits are so sophisticated that they usually only focus on two or three key figures and ignore time consuming items that are largely inconsequential.
While the exact formula is a closely guarded secret, some of the data is public. From this we know that the audit rate for those making over $5 million per year jumps to around 10%. Similarly, the audit rate for those reporting losses is just over 6%. Corporations face audits at only a tenth of the rate of individuals, and self-prepared returns are more than twice as likely to be audited than those prepared by tax professionals. Only 1% of those audited receive a "no change" letter, meaning they cannot be audited again for three years—a rarity in the tax world.
There are several types of IRS interactions that are technically considered audits but are not included in these statistics. The most common, affecting about 4% of taxpayers, are “math-error” notices, which, despite their name, seldom involve simple arithmetic. Instead, they address things like attempting to claim a child already claimed by someone else or failing to report a health-care subsidy. We saw a surge in these during Covid-19 from people trying to double-dip their stimulus payments. These are usually issued within a couple months of filing and while the IRS is generally accurate in these situations it’s still best to have your notice checked by a tax pro before paying. There is always a chance that the IRS is wrong and there may also be unaddressed state tax implications.
The second most common type are under-reporter notices. These typically arise from omissions like forgetting to include a W2 or 1099 form. They usually appear about 12 to 18 months after a return is filed and often resolve in the taxpayers favor with a simple letter.
Questions about audit risk used to bother me as a young practitioner because I felt like doing the right thing should not be dependent on your chances of getting caught. After all, filing a tax return is a statement made “under penalty of perjury”, not an opening bid at an auction. In other words, we should always do the right thing even when no one is watching. Having said that, there are times when the law is unclear, and our policy is to interpret such matters in our client’s favor whenever possible. This is the fine line between evasion and avoidance. As Will Rogers so aptly put it, “Even when you make a tax form out on the level, you do not know when it is through if you are a crook or a martyr.”
You likely know someone who is a tax cheat. It’s estimated that at least10% of the GDP goes unreported each year. The IRS refers to this as the “tax gap”, economists call it the “shadow economy” but all agree that it is widened by increased regulation and tax burden and that once it starts, it is difficult to reverse. Enforcement thus becomes an invaluable function in preserving this first of three necessary tenets for a fair tax system (the other two being reasonableness and simplicity).
When we file and pay our taxes, we need to know that our neighbors are doing the same. Another famous Will Rogers quite is that “The income tax has made more liars out of the American people than golf.” Our lawmakers owe us a duty to keep that in check.
Some of our best clients are the ones who have been audited because they understand that it is something we want to respect but not fear. Our firm has an exceptionally low internal audit rate which we are very proud of but we represent a lot of clients with self-prepared returns or even returns by other practitioners.
How do I avoid an audit?
Ironically, you don’t avoid an audit merely by being honest; instead, you avoid things that appear dishonest or draw attention. For example, excessive business use of your vehicle or an overly aggressive home office deduction might be considered red flags. Other suspicious deductions include things like boats, travel or large charitable contributions (something we run into a lot here in Utah.)
Choosing your battles is another strategy. With the rate being so low these past few years, a lot of people have gotten away with questionable behavior. Now that audits are on the rise; you could find yourself facing scrutiny for the same sketchy tax strategy that your neighbor got away with just a year or two earlier. A relevant proverb here is that “pigs get fed and hogs get slaughtered.”
Avoiding an audit is not an exact science. It seems to follow Murphy’s Law in that the more prepared we are the less likely it is to happen. I have clients with beautifully kept books and detailed mileage logs that will likely never face an auditor. Others give me their info on a post-it note that may be perfectly accurate but keep me up at night because of their suspicious appearance.
Years ago, I had a high-income client with an aggregate tax rate of around 10%. He took his info to a guy in Utah County who called himself “the tax doctor” for a second opinion and was incredulous when this guy somehow got his tax rate down to zero. A year later, "the tax doctor" went to prison for tax fraud and all his clients were audited. My client was too embarrassed to come back but a mutual friend said he was a lot more conservative after that experience.
We have a tax code that favors those with the best accountants. My hope is that you never have to endure an IRS audit but if you do, please don’t go it alone! Call us, or a local Enrolled Agent specializing in IRS representation. We have the skills to keep the IRS from abusing their power. And if you are unfortunate enough to owe additional tax, remember the words of Oliver Wendel Holmes who said, “I like to pay taxes, with them I buy civilization.”
Stay safe my friends.