Audit “Flags” – Straight from the Internal Revenue Manual

Large Unusual Questionable Items (LUQs)

The definition of a large, unusual, or questionable item will depend on the examiner’s perception of the return as a whole and the separate items that comprise the return. Some factors to be considered when identifying LUQs are:

1. Comparative size of the item — an expense item of $6,000.00 with total expenses of $30,000.00 would be a large item; however, if total expenses are $300,000.00, the item would not be generally considered a large item.
2. Absolute size of the item — despite the comparability factor, size by itself may be significant. For example, a $50,000 item may be significant even though it represents a small percentage of taxable income.
3. Inherent character of the item — although the amount of an item may be insignificant, the nature of the item may be significant; e.g., airplane expenses claimed on a plumber’s Schedule C.
4. Evidence of intent to mislead — this may include missing schedules, incomplete schedules, misclassified entries, or obviously incorrect items on the return.
5. Beneficial effect of the manner in which an item is reported — expenses claimed on a business schedule rather than claimed as an itemized deduction.
6. Relationship to other items — incomplete transactions identified on the tax return. For example, the taxpayer reported sales of stock but no dividend income.
7. Whipsaw issues — occur when there is a transaction between two parties and characteristics of the transaction will benefit one party and harm the other. Examples include alimony vs. child support, sale vs. rental/royalty, employee vs. independent contractor, gift vs. income.
8. Missing items — consideration should be given to items which are not shown on the return but would normally appear on the returns of similar taxpayers. This applies not only to the examination of income, but also to expenses, deductions, etc., that would result in tax changes favorable to the taxpayer.

The foregoing is an excerpt from the Internal Revenue Manual.  These are some of the recommended procedures to IRS Agents when doing background work before a taxpayer is contacted.

The tax return would have been flagged already.  It is now in the hands of the scrutinizing IRS Agent.  These are some of the items the agent will look at closely before contacting the taxpayer.

Click here to read about IRS Audits including IRS letters.

Excerpt from Publication 1, Taxpayer Rights

The process of selecting a return for examination usually begins in one of two ways. First, we use computer programs to identify returns that may have incorrect amounts. These programs may be based on information returns, such as Forms 1099 and W-2, on studies of past examinations, or on certain issues identified by compliance projects. Second, we use information from outside sources that indicates that a return may have incorrect amounts. These sources may include newspapers, public records, and individuals. If we determine that the information is accurate and reliable, we may use it to select a return for examination.

The same issues an examiner looks for can often be identified before an audit. Our tax compliance review examines filed returns and related records for inconsistencies, unusual items, missing information, and other potential examination exposure.