The IRS conducts audits on approximately 2% to 3% of individual tax returns submitted every year. Because there are about 130 million tax returns individual tax returns filed annually, about 4 million of them will be audited.

There are several methods the IRS uses to determine if which tax returns to audit. Three of the most common are:

1. The Differential Income Factor (DIF) Method. Each tax return filed with the IRS is assigned a score based on the amount of income reported and the kind and amount of deductions claimed. The IRS will include tax returns in the pool of returns for auditing if the DIF score a tax return receives exceeds a particular threshold for income reported on the return. The higher the expenses relative to the income, the higher the DIF score.
2. The Information Returns Factor Method. The IRS receives copies of all W-2s and 1099s every year. The IRS also records the social security numbers from these documents and matches them to the social security numbers on the tax returns that are filed. If a taxpayer fails to report all of the income from their forms W-2 or 1099 on their tax return, the IRS will catch this discrepancy. This discrepancy will help to select that taxpayer’s tax return for audit.
3. The Random Selection Method. All tax returns receive a random, computer-generated number. Tax returns with high DIF scores and non-matched information are taken out. A certain number of these tax returns are picked at random to audit.

Once the IRS has selected a pool of tax returns for auditing, they are assigned to Internal Revenue agents and revenue officers. When a tax return is chosen for audit, it is assigned a certain transaction code (TC). The TC identifies it as being selected for audit.

Every taxpayer who submits tax returns to the IRS has a record that is maintained by the IRS. These records are known as Individual Master Files (IMF). Since 1974 the Freedom of Information Act has allowed taxpayers to access their IMFs. The IMF provides data on a computer-generated report concerning each taxpayer the IRS has on record. The IMF can reveal whether a taxpayer’s return

• has been received by the IRS
• has been selected for audit
• has been assessed additional taxes
• what the final collection date is for the tax return

Agents are assigned individual audits up to six months before the taxpayer is even notified of an audit. Therefore, a copy of the taxpayer’s IMF can tell him or her whether the taxpayer’s tax return has been selected for audit.

The most likely groups to be audited are taxpayers who own sole proprietorships. These taxpayers file a Schedule C that is attached to their Form 1040. Taxpayers with high incomes are also frequently targeted for audits. Others likely to be targets of auditors are taxpayers who work in businesses that conduct a lot of businesses in cash, for example, owners of bars, restaurants, vending machine services, or laundromats. This is true whether or not the taxpayer files Form 8300 (Report of Cash Payments Over $10,000 Received in a Trade or Business). On the average, cash businesses are subject to auditing much more than other types.