One of the most common questions I am asked when I tell people that I am tax attorney is whether the filing of an extension to extend the due date of their income tax return increases the risk that their tax return will be audited. The IRS allows taxpayers to file an extension request by filing an IRS Form 4868 by the April 15th deadline. The filing of this form automatically extends the due date for the tax return for an additional six months. This form is extremely easy to complete and does not even require the taxpayer’s signature. Thus, the lure of the filing an extension is substantial.
Some practitioners believe that filing an extension increases a taxpayer’s audit risk. I disagree. While it is likely that there is a greater probability of an audit for returns filed on an extended due date, I do not believe it has anything to do with the actual extension. Rather, the IRS uses several different methods to select a tax return for audit. Most commonly, taxpayers’ returns are selected for audit through the IRS’s computer screening programs. Nowadays, the IRS does not have the budget to expend resources and time auditing returns that do not result in a tax assessment. Accordingly, very high tech computer scoring and selection programs have been developed to identify the returns that are most likely to result in additional tax being owed. The IRS’s computer screening programs look at two simple formulas and scores to determine whether to select a tax return for audit. These two scores are computed under the IRS’s Discriminate Inventory Function System (“DIF”) score and Unreported Income Discriminate Index Formula (“UI DIF”).
The DIF score is a numeric score computed by the IRS’s Discriminate Inventory Function System for each individual and some corporate tax returns. This computer program identifies and selects tax returns for examination by utilizing a scoring system. A higher DIF score increases the potential for an IRS audit examination. Essentially, this scoring system compares the income tax return against the “norms,” for other similarly situated taxpayers. These “norms” are developed by the IRS based upon audit history and statistically valid sampling of returns. A taxpayer’s return will receive a higher DIF for larger deviations from the norms. For example, if the taxpayer has a large family size and lives in a high-end residential area but reports a very low (and below normal for the area) income, the return will score a higher DIF and will have a higher likelihood of being selected for audit.
In addition to the DIF score, the IRS also uses the Unreported Income Discriminate Index Formula (UI DIF) to rate the probability of inaccurate information on an income tax return or the probability of omitted income on the tax return. This audit selection program generally targets four types of returns/taxpayers for audit selection: (1) high income high risk taxpayers, (2) high income non-filing taxpayers, (3) high itemized deduction taxpayers, and (4) self-employed taxpayers (taxpayers filing a Schedule C).
While many practitioners believe that filing an extension increases the audit risk, I do not agree. Rather, I believe that taxpayers who tend to file extensions are naturally within the groups that are typically subject to a higher audit risk. Specifically, taxpayers who are with self-employed, high income, and high itemized deductions are generally the type of taxpayers that require additional time to complete their complex tax return. In contrast, W-2 employees with the normal standard deduction are less likely to need to file an extension and are automatically at a much lower audit risk.