The audit lottery, or preparing for the TCMP audit - again!

Generally, only about 1% of all individual income tax returns are audited. Thus, the IRS employs several techniques for selecting returns to examine in order to use its audit time most efficiently.

Selection process

After the initial checks, information on returns is processed by computers and rated for potential errors by a selection program known as the Discriminate Function System (DIF) - a statistical analysis that assigns number values to various items on the return and thereby produces a composite score for each return. There are numerous possible formulas for weighing the data to calculate the composite score, but the exact formulas are withheld from the public. The standards used in developing these formulas are based on the results of examinations from previous years, particularly the results of the Taxpayer Compliance Measurement Program (TCMP). Representatives from IRS district offices screen those returns that have significant DIF scores, and agents evaluate these returns to determine the potential for adjustment versus the costs of the examination.

The DIF formulas used to determine which returns should be audited are updated using information received from the TCMP. The TCMP selects random returns and subjects them to a thorough audit that examines every aspect of the return. During a TCMP, the taxpayer may be required to furnish the examiner with marriage certificates, birth certificates, cancelled checks, deposit slips, receipts and any other item that might be needed to verify every entry on the return. These other items could include casino earnings, U.S. Customs reports, foreign bank account information, motor vehicle registration data, etc. Full compliance with TCMP audit procedures by IRS field agents is mandatory, which makes it time-consuming and expensive to the taxpayer (as well as time-consuming and frustrating to the tax practitioner).

In addition, because these audits attempt to "scientifically" measure the degree and extent of taxpayer compliance, returns selected for audit must be examined. The only accepted reasons for avoiding a TCMP audit are: * The taxpayer is outside the United States and unavailable for an interview. * The taxpayer cannot be located. * The taxpayer is too ill, has become incompetent or has died, and the guardian or executor cannot be located.

The AICPA's Tax Practice Management manual suggests that there have been reported instances of practitioners getting TCMP audits waived on grounds that the taxpayers had a "no-change" audit in the previous year; however, normal practice has proven this quite unusual. (The manual is an excellent source book on how to deal with the Service, specifically, how to handle IRS audits; assessment and collection issues; the appeal process; claims procedures for obtaining a refund; using letter rulings, determination letters, technical advice memoranda and closing agreements; programs for problem resolution; and the Taxpayer Bill of Rights.)

The Service has recently announced that by October 1995 it will begin the largest cycle of TCMP audits in its history. The last major performance of TCMP audits was conducted in 1988; the IRS is now tripling its efforts to include 153,000 tax returns: approximately 93,000 individual returns, 12,500 partnership returns, 12,500 S corporation returns and the balance of small C corporations, with some controlled foreign corporations (but no fiduciary returns or nonprofit organizations). The returns selected for audit are expected to be from those that are filed between Jan. 1 and Dec. 31, 1995, including any amended returns filed during that period.

The 153,000 returns are only the "primary" returns to be examined under the TCMP program; this number does not include the related entity returns that will also be audited as part of this program. However, the Service claims that the "related" entity tax returns will be examined under routine audit, and not be subject to TCMP audit guidelines.

The entire TCMP program is expected to be a two-year cycle, with a maximum of 30 months to complete the cycle. As of this time, the Service has not estimated how long any one particular audit should last. Note that this 30-month period does not include any appeals or civil (or possible criminal) litigation that could result.

Audit procedures

As part of the TCMP program, the IRS has developed a checklist of 439 Form 1040 line items, and a smaller list for the corporate and partnership returns. The purpose of this checklist is purportedly to suggest items for further investigation, rather than verification by the auditor. Currently, it is not known whether the checklist will be made available to the public. In addition to the checklist, the Service intends to apply the "economic reality" concept of the taxpayer's tax situation. While the IRS maintains that these are not "lifestyle" audits, comparing a taxpayer's lifestyle to the amounts reported on his tax return will be a significant part of the agent's main focus. Practitioners have been led to believe that, as part of this "economic reality" investigation, it might not be unusual for an agent to drive by a taxpayer's personal residence to obtain physical proof of his living conditions. The IRS states, however, that it will not be using any unmarked "surveillance" cars for this purpose, but rather, each individual auditor would use his own car if such investigation is deemed necessary.

In a change from past TCMP audits, the proposed audits are to be stratified by market segments; the Service has defined 28 classifications for this purpose. A market segment represents a group of taxpayers with similar characteristics. Twenty-seven of the classifications are fairly specific; however, the twenty-eighth classification is anything else not included in the previous 27. Naturally, the biggest target of the selected Form 1040s is those with a Schedule C, particularly those with potentially unreported income. One of the results of the TCMP audits will be to expand the Standard industry Code (SIC) list for future use.

What can tax preparers expect to face as to how these audits will be conducted? The 153,000 returns to be examined are spread across the entire country. The Chief of the Examination Division of the IRS Los Angeles District Office has stated that about 6,000 of these TCMP audits will be conducted in the Los Angeles district. He also indicated that as a result of each entity for which a TCMP audit is performed, there will be, on average, two other "related entities" audited. Therefore, 6,000 TCMP audits will generally produce 18,000 total audits; assuming the Service is consistent on a nationwide basis, the 153,000 TCMP audits will produce 459,000 total audits. The 153,000 returns pulled for audit represent only 6/10 of 1% of all filed tax returns. Thus, the IRS maintains that no one practitioner should be unduly burdened by this cycle.

The most difficult issue facing practitioners may be the level of training of the IRS auditors, rather than the volume of returns selected. The Service estimates that about 25% of its revenue agents and auditors are brand new; thus, tax practitioners may be forced to provide "on-the-job training" for them. Not only is the IRS going to have to train its agents on technical tax issues more stringently than ever, it will have to train them even more diligently on the "economic reality" concept. Practitioners have been told that the training efforts will include methods to understand "available cash" as an indicator of the taxpayer's lifestyle, as well as different scenarios for accumulating assets without necessarily accumulating taxable income.

Remember, the TCMP selection process will be based on a random sample, so no particular issue or approach to reporting a transaction on a tax return will have an impact on its selection or nonselection. It is truly one giant audit lottery.

Editor's note: Mr. Bobrow and Ms. Kauls are members of the AICPA Tax Division's Tax Practice Management Committee.