November 1998 Issue



By H. Wayne Cecil

Audits are a very important part of the IRS's efforts to assure compliance with Federal income tax laws. However, auditing returns is only one element of the IRS's compliance strategy. Two additional components are the use of nonrandom methods to select returns for auditing and the electronic matching of third party information documents (Form W-2s, Form 1099s, etc.) to returns.

Audit Rates

The IRS classifies individual returns into ten categories based on total positive income (TPI) for nonbusiness returns and total gross receipts (TGR) for business returns. The audit rate for each category is computed by multiplying 100 times the number of audits performed during the year and dividing by the number of returns filed during the year. The number of audits performed is primarily for returns from one of the three prior years while the number of returns filed is for the current year. Table 1 reports audit rates by category for 1992 through 1996. As Table 1 shows, the frequently reported audit rate of one to two percent is not accurate for six of the ten categories. Table 1 also shows that audit rates for high-income, nonbusiness returns and business returns are about twice the 1.67% overall rate.

The U.S. General Accounting Office (GAO) reports that audit rates also vary by geographic location. The difference in rates across the United States is attributed to differences in compliance, with higher noncompliance in the western and southwestern regions and lower noncompliance in the central and eastern regions.

Selection Methods

The returns selected for examination are not chosen randomly. The IRS's policy is to identify and audit those returns with the most potential for noncompliance. This policy better utilizes limited funds and helps avoid burdening compliant taxpayers with unnecessary audits. The IRS reports that its programs to identify and audit those returns with the most potential for noncompliance has helped to decrease its "no change" findings from more than 40% to approximately 15% of all individual audits. Nonrandom selection of returns means that the popular belief that audit rates represent the statistical chances of being audited is not accurate.

The IRS uses several nonrandom methods to select returns for auditing purposes. Table 2 reports the sources of audited returns for the preceding three years. It shows that unallowable items accounted for 42% of all audited returns for 1996. The second most important source (18%) of audited returns was discriminant function analysis (DIF), a sophisticated scoring system that relies on statistical data collected from the most recent Taxpayer Compliance Measurement Program (TCMP), which was last performed in 1988. TCMPs involve detailed audits of random samples of returns, and there is no plan for a TCMP in the near future. The third most important audit source (11%) was the nonfiler program, while the fourth (4%) was the state information program. Together, these methods accounted for 75% of all audited returns for 1996.

Does claiming a refund (instead of applying an overpayment) increase the chances of being audited? Table 2 shows that claims for refunds represented only about two percent of all returns selected for audit. Does filing an extension increase the chance of being audited? While an extension does increase the time period during which a return can be audited, Table 2 provides no evidence that an extension by itself increases the likelihood of an audit. An extension, however, could be one of several items that increases the DIF score of a return.

Electronic Matching-Auditing?

Audit rates reported in Table 1 are based on a recently revised definition of "audit" for statistical purposes. The revised definition encompasses the traditional face-to-face contacts between taxpayers (or their representatives) and auditors plus IRS service center contacts (correspondence audits). The definition of audit has been revised to exclude contacts relating to the IRS information reporting program. A full appreciation of the IRS's ability to examine the accuracy of returns requires going beyond the revised definition and considering the matching system.

The IRS information reporting and matching system represents the electronic verification of more than 90% of all income and more than 40% of all deductions for individual income tax returns. This translates into the complete electronic verification of all income and deductions for more than 45% of all individual returns. While not meeting the definition of audit in the traditional sense, the story is incomplete without consideration of the electronic matching program. GAO provides a more complete discussion of the electronic verification of the accuracy of individual income tax returns. *

H. Wayne Cecil, PhD, CPA, is an assistant professor at the University of Southern Mississippi.

Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editor:
Richard M. Barth, CPA

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