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Nobody wants a run-in with the IRS. I had my own little problem over a year ago after my mom cashed in some investments to help pay for my college education. Let me tell you, straightening that mess out was no simple task. Even after a visit to my local IRS office and to a CPA-friend of one of my professors, no one could clearly explain why the IRS was requesting that I pay this hefty sum of money. In fact, they were all telling me to just pay up. After almost six months of going back and forth with the IRS, someone at the agency was able to clearly explain the situation.
It all came down to capital gains tax. When the income was reported, it looked as though I’d made 100% profit on the investment, which meant I’d have to pay taxes on the income. But the truth was, the investments were liquidated at a loss and I really didn’t owe anything. Though I was not audited, I can imagine the rigmarole one must go through. Ever wonder how the IRS chooses to audit someone?
While browsing around online, I stumbled upon a blog post by Jim Wang over at Bargaineering about how the IRS picks who it’s going to audit. Given that tax season is ramping up, I thought there were some important things we should all be aware of.
Apparently the IRS published this information on its Website in 2006, detailing how it determines which tax returns to audit. Check it out:
Computer Scoring – Computer programs give each return a numeric “score.” The Discriminant Function System (DIF) score rates the potential for change based on past IRS experience with similar returns.Â The Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income.Â 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.
Information Matching – Some returns are examined because payer reports, such as Forms W-2 from employers or Form 1099 interest statements from banks, do not match the income reported on the tax return.
Related Examinations – Returns may be selected for audit when they involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for examination.
Potential participants in abusive tax avoidance transactions –Â Some returns are selected based on information obtained by the IRS through efforts to identify promoters and participants of abusive tax avoidance transactions.