How the IRS actually audits taxes
In the summer of 2022, I attended an event in Dallas, TX with about 40 of the most experienced tax auditors at the IRS. These were the leaders of the 4 core business units in the IRS which audit all, or nearly all, federal tax returns at the IRS. It was a 3-day event that we can refer to as somewhat of a “large group working session”. The one-liner objective was to “determine a unified exam process” for the IRS.
Before we go too far, let's address why I was there and my role, as well as cover a little background on IRS terminology and the processes at the time. This might be boring, but it really helps to understand exactly how the IRS handles exams.
I was a contractor for the IRS building out their processes into a new technology, Pega, which I was an expert in. For this specific event, I was invited to be the Lead Elaborator, meaning I had the responsibility of collecting “what the business needs to perform their required outcomes”, and translating that into actionable work for a software engineer to build into working code. If you are unfamiliar with this type of work, it likely sounds fancier than it is. Basically, this required me to understand their process at the most detailed and granular level possible in order to make sure the software we built was both comprehensive and clean. If we designed it with a certain approach, only to later discover additional relationships between data and functionality, it results in cumbersome or irrelevant software. Thanks to this experience, I am able to understand the IRS’ Examination process at the most detailed level, both from the overall “how it works”, as well as the “how is it performed, and how does each data point affect the overall process”.
Now for some terminology and context. Exam is the IRS term used to what most Americans think of colloquially as an audit. This comes from the fact that any information filed with the IRS that is identified as questionable, is then referred for Examination. No single centralized group at the IRS performs these Examinations. Instead, each business unit will examine the tax returns that are determined to fall under their jurisdiction. There are several business units at the IRS, at the time of this writing in 2024 it is more than 20. The 4 core business units which handle nearly all of the examinations, and the 4 which attended the 2022 Dallas conference, are: Wages and Investment (W&I), Small Business and Self Employed (SBSE), Tax Exempt and Government Entities (TEGE), and Large Business and International (LB&I).
Each business unit had their own way of performing examinations and didn’t work with the other business units on their steps. You can see how this would create a problem when you are trying to build software. With so many unique approaches, it would require you to build a very large number of unique pieces of software to handle it. Imagine taking a course about “building a house”, but each lesson was built by a different teacher, with no collaboration from the other teachers. The chaos of overlap, repeating information, and such would make a course 5-10x longer than necessary. The outcome may even be too incoherent to provide value. The IRS would be in a similar situation in their current decentralized process for examination.
Naturally, the IRS had the goal to then build a single overarching Exam software application and workflow for all Exams performed. This now brings us back to the 2022 Dallas event.
On the 3rd day of the event, we had been going step by step through the entire exam process, allowing each business unit to interject at the greatest level of detail. These were long days for me since I was not a leading expert in the examination process, let alone each business unit’s unique approach. As the participants were discussing, one IRS agent from the LB&I team was describing how they handled a specific part of the process. Now remember, we are over 2 days into this, so these discussions had happened for several hours already on each and every step. Finally, a team member from the TEGE unit spoke up and said “Wait, I now realize, you do the same stuff we do, just more of it”. Bing, a light bulb went off in the room (metaphorically). Everyone from the IRS had a moment of realization together, they weren't so different after all.
For reference, LB&I audits large businesses, so they tend to go through the same steps everyone else does, they just have to do them for more returns. As an example, if an individual gets their 1040 return audited, and they have just 1 investment account, and 1 job, their return is simple. But what about a large corporation, it could own 10+ subsidiaries, have hundreds of accounts, meaning many many tax returns feed into this 1120 tax return. The LB&I team would examine them all the same, but they would potentially have to examine all those returns, instead of just one 1040.
With this understanding that all of the different business units actually all do the same thing, even if they use slightly different forms, different terms, or different systems, we are now able to outline the generic IRS Audit Process.
IRS Audit Process
Disclaimer, the audit process below is public information on the IRS website in their IRMs (Internal Revenue Manuals). The process below does include some gratuitous interpretations, oversimplifications, and commentary from me using my personal thoughts and experiences. This is a generalization and used for illustrative purposes, you can easily poke holes in my statements below, but the overall idea process is correct, and the points I drive home are accurate. Enjoy!
The first step is overly obvious, but still needs to be called out, the IRS receives the tax return. Paper returns are scanned into the system and then stored in the MTRDB, e-file returns are stored in the MeF (Modernized e-File).
Next, the IRS runs their proprietary and unknown algorithm called the Discriminant Function (DIF). I have not seen it and have no inside knowledge of it, I dont believe anyone that knows the exact data would be allowed to share it. From an intuitive perspective, the DIF provides a risk score for the return by benchmark ranges.
These benchmark ranges are by income amount, expense type, deduction type, tax credits used, and so on.
For a simple example we will use one of my Anytime Fitness locations. We did around $500,000 in total annual revenue, here is a high-level breakdown of some expenses by category
Revenue $500,000
Cost of Goods sold $10,000
Advertising $6,000
Rent $100,000
Utilities $15,000
Wages $100,000
Cleaning Supplies $10,000
Equipment Repairs $6,000
Office Supplies $3,000
Without knowing the exact DIF calculation for a fitness center business code number, we can intuitively understand there are ranges. If I had been spending 80% of my revenue on Rent, this would likely increase the DIF score risk rating. Same goes for all the categories, there is an intuitive range that most businesses will be spending, in your same industry / business code number.
Now imagine a retail business. If it has a store front, you would assume their rent and cost of goods sold to be a very large share of their revenue. What about an online retail business with no store front? Just a storage center, maybe much smaller rent costs, but very high shipping expenses compared to the Anytime Fitness above.
Based on the DIF score, the returns are then sorted, and the highest risk returns are then selected for the next step. The exact number depends on the IRS’ capacity, it could be 100,000, or 700,000, depending on the type of return, but for most recent data in FY2023, about 4.5 million total notices were initiated, these are mostly automated notices, such as someone did the math wrong calculating their AGI. Of the approximately 4.5 million notices, 2,600 criminal investigations were opened.
Now any return that is selected for examination is evaluated for “Issues”. These are the core concepts of an exam, so pay close attention here. This is also where you can have the fallacy of “my uncle got audited and he didn’t get in trouble for doing blah, blah”.
The system will scan the return and, based on similar logic and outputs from the DIF, create Issues for each discrepancy it finds. For example, if in the Anytime Fitness example above, the Rent was $400,000, the DIF would mark that as an issue since it is absurdly high compared to the revenue, industry, and such.
The Issue for “Rent Costs” is now created by the system. Each Issue has its own set of steps that need to be completed. For a Rent issue, usually the steps would involve an IRS Agent sending correspondence to the taxpayer requesting additional receipts, maybe a copy of the lease, maybe even direct communication with the landlord too. They will then verify if the amount stated is accurate, meaning it has receipts and it is a true business expense without any personal expenses in there. If it is accurate, the exam is closed and no additional actions are required.
Wait, let's back up a second. A tax return was identified to be audited, and issue was identified, that issue was audited… and then the audit was close. When did they look at all the other expenses? Exactly, the short answer is they didn’t.
To be fair, they do usually give a general review of the return to see if there are other issues the system didn’t identify, but again, if the numbers appear to be in proper ranges, then no other issues are identified.
If no other issues are identified, then nothing else is reviewed, examined, or audited on the tax return. Read that again. If no other issues are identified, nothing else is audited on the return.
Let's play with this a little bit then. Imagine your uncle always expenses his phone plan, for the whole family, onto his business account. He tracks the expense, categorizes them appropriately, and adds them to the total for “Utilities” on his tax return. Maybe he also does the same for his electric bill at his house, which he doesn’t use for his business address. He then gets audited in the same way we showed above, his Rents have an issue, he submits proper receipts and the IRS closes the audit with no additional payment required. But he had personal expenses deducted on his taxes, that’s not correct. Now we know how this can happen, the classic “I’ve always done it this way, even got audited, and it wasn’t an issue, therefore, it's correct.” You now know your uncle, or friend, wasn’t likely lying about their situation, but they also aren’t correct in stating “this is the correct way to expense personal items”, what they really mean is “here is how I have done it and avoided getting flagged for an issue”.
In 2023 of the approximately 4.5 million notices the IRS sent, 2,600 criminal investigations were opened. This shows the very small instances of Tax Fraud or Tax Evasion that are found AND pursued by the IRS. The IRS does find more instances than these 2,600 cases, but they usually just penalize the taxpayer and have them fix the issue. See IRC 6662 and 6663.
Once all issues are resolved, the outcome can be a balance owed, a criminal referral, an appeal, and other items. The IRS proceeds as such. I don’t want to go beyond this since its hopefully irrelevant to our required knowledge.
*For individual tax returns (Form 1040), one of the largest audit triggers is tax credits. Those cause the most “issues” to be identified, and a lot of those are automated now, changing the process slightly, but doesn’t change the overall picture. The process that has been described is generic, but meant to be more specific to a business’s tax return and not an individual (except for the instance of 1040 Schedule C).
What to do with this information
Let that sink in for a minute, or maybe a day, or honestly maybe a couple of weeks. Did you really just read that? The IRS will audit taxes, and as long as the high-level numbers align with benchmark ranges, you will not be asked for proof of expenses.
I am sure you have so many questions. Let's address them 1 at a time.
Question 1: Can I start expensing personal items with my business?
Ahhh yes, naturally we quickly become greedy, jealous, maybe even resentful of how stupid we feel. Don't feel stupid, just because something can be done, and you can get away with it, doesn't mean it's right. Ethically, morally, and of course according to the tax code, the answer is simply No. The IRS tax code still requires all business expenses to be for business purposes only. If you have a family phone plan, you should keep receipts, track usage, and only expense the amount that is business usage. Same goes for utilities, if your personal residence is not 100% used for business purposes (which it really never can be) then no, you can't expense your utilities. And on, and on. Again, this should change nothing in how we file our taxes, or how we approach filing them. One oversight too can be ‘piercing the corporate veil’ of your legal entity, likely an LLC. True it can be worked around, which we will address in later chapters, but its still a risk of mixing personal expenses with business expenses which makes for quick work by an attorney. But I digress, the answer is no, you cannot expense personal items to your business in general.
Question 2: How can I know if my CPA, or whoever I have track expenses, is doing a good job?
Now you see why I am writing this, huh? You need the tools to better understand the risks you face. We also see the struggle with what defines a “good job”. Before, we likely thought, whoever saves me the most money on my taxes is doing the best job. Now maybe you question that a little bit more. We will break down, in detail, how to review taxes, how the categories all tie together, and how to best understand them. We will cover bookkeeping, corporate structure, and many other things. These tools will give you the skills to verify your finances. You wont have to be the one doing the bookkeeping, tax filing, and such, but you will have the know-how to review their work and make sure it is done to your liking.
The short answer is, you will have to read future articles and use the skills obtained here-in in order to really know… or you can always just hire us at Gym Financial Officer since we show you in simple reports and easy transparency all this information to make it easy… just a quick shameless plug.
