When you want to make a loan application for a house purchase or any other borrowing from a bank or a finance agency, you become aware that a credit rating exists on you, based on various criteria including a history of paying prior loans on a timely basis, adequate income to support loan repayments, and various other factors.
It turns out that the IRS also keeps score on filed tax returns, as a means for selecting additional tax returns for future audits. The IRS term “Discriminate Function” is their name for this process. To quote from the IRS Publication 556,
“Your return may be selected for examination on the basis of computer scoring. A computer program called the Discriminate Inventory Function (DIF) assigns a numeric score to each individual and some corporate tax returns after they have been processed. If your return is selected because of a high score under the DIF system, the potential is high that an examination of your return will result in a change to your income tax liability.”
Some of the conditions that make an IRS tax examination more likely include:
1. High Income. The overall audit rate for filed tax returns is about 1%; it increases to about 12% if your income is $1,000,000 or higher.
2. Failing to Report Taxable Income. For many taxpayers, part of their income is reported to the IRS electronically including wages, interest, dividends, consulting services, capital gains, and so on. The IRS matches the amounts you show on your tax return to their records, and if there are differences, you may receive a IRS notice assessing additional taxes.
3. Taking large charitable deductions as a percentage of your income. For non cash donations over $500, you are required to include IRS Form 8283, which provides details regarding the gift; for donations over $5,000 you need an appraisal.
4. Claiming a home office deduction for business use of a portion of your home. There are detailed requirements regarding expense documentation and use of space.
5. Deducting real estate rental losses. If you own residential or business real estate, and real estate management is not your primary occupation, you may have a tax loss on the rental activity. This is not unusual when depreciation expense is considered. But you begin to lose the tax benefit of the rental loss if your adjusted gross income is more than $100,000, and the benefit is phased out when your AGI exceeds $100,000.
6. Failure to keep adequate records regarding business travel, entertainment, and automobile expense.
7. Being engaged in a proprietary business that is not profitable. The IRS may question the business nature of your effort if you do not make a profit on 3 out of 5 years, and consider your activity a “hobby”, not entitled to business deductions.
8. Running a cash business. The IRS is concerned that cash based businesses such as restaurants, do not report all of their income. Their audit guide instructs agents how to test cash-intensive businesses, including how to interview owners, and noting various ways that income may not be reported.
9. Failing to report foreign bank accounts. You are now required to file the IRS form TD F 90-22.1, Report of Foreign Bank and Financial Accounts by June 30 of each tax year.
In 2011, the IRS established an Office of Compliance Analytics whose mission was “to materially improve tax compliance and develop a more robust data-driven, analytic culture across the IRS ….” Clearly, the IRS is not reducing its data sampling techniques for US filed income tax returns.
In 2011, the IRS established an Office of Compliance Analytics whose mission 
was “to materially improve tax compliance and develop a more robust data-driven, analytic culture across the IRS ….” Clearly, the IRS is not reducing its data sampling techniques for US filed income tax returns.