As a business owner, there aren't many
things worse than receiving an audit letter
from the IRS. It is not the
specter of being "found out,"
because most business owners
file properly prepared tax
returns and have nothing to hide.
The real aggravation stems from
the amount of time, money and
effort it takes to prepare for and
defend against the actual audit.
For most companies subjected
to an audit, it is a bit of a mystery
as to why they were selected in
the first place. In truth, the reasons vary.
The IRS randomly selects some companies
for audit. It goes on tips from time to time.
However, in most cases, to determine which
companies will be audited, the IRS uses a
"discriminate function" score (DIF). This
DIF system is quite complex and is actually
a "black box" in some regards.
The IRS guards the formula as if
it were the recipe to Coca-Cola
and, in fact, it is probably worth
quite a bit more. What goes into
this score? No one other than its
designers knows for sure, but
experts who study audit activity
claim with fair certainty that
some of the factors the DIF formula
takes into account are:
Your business type: Businesses
that deal with large amounts of cash are
more closely scrutinized. Also, it is believed
that the IRS targets selected industries with
"special attention" each year.
Where you live: Audit rates differ widely according
to where you live. A few years back, for example, taxpayers in Southern
California were nearly five times more likely to be audited than taxpayers
in Georgia. The IRS no longer releases data on audit rates by region.
The amount of your deductions: The larger the deduction
in relation to your total revenues, the greater likelihood of an audit.
Hot-button deductions: The IRS has certain deductions
that just seem to be "audit magnets." In the past they have been things
like high travel and entertainment expenses.
Businesses that lose money: The IRS pays attention
to these types of business for a very simple reason. If a company is
continually losing money, why would it continue to operate from year
to year?
Deductions that seem out of place: Deductions that
seem "out of place" for your industry could raise your DIF score. What
if an accounting firm spent a lot of money on tools? Or if an auto mechanic
deducted costs for a trip to Europe? The IRS would suspect these types
of deductions as being illegitimate.
Your entity structure: Sole proprietors are the most
likely targets for auditors. In fact, they are ten times more likely
to be audited than partnerships and small C-corps.
Your body fat percentage: Not
really, but if they did count it,
we would all be in trouble.
