How Taxpayers Are Selected for Audit Using DIF Scores

The IRS uses a computer scoring system called the Discriminant Inventory Function (DIF) to evaluate tax returns for potential audit. The DIF score is based on a mathematical model that compares a taxpayer’s return to statistical norms derived from IRS data. Returns with unusually high or low DIF scores—indicating potential errors, misstatements, or fraud—are flagged for further review. Higher DIF scores suggest a greater likelihood of discrepancies or underreporting, prompting potential audit selection.

The IRS also utilizes the Unreported Income DIF (UIDIF), which specifically targets cases of potential unreported income. However, not all flagged returns result in an audit; the IRS manually reviews many flagged returns before initiating further action.

How the IRS Uses NAICS Codes to Assign Classes to Businesses

Businesses are required to report their North American Industry Classification System (NAICS) code on tax returns. This six-digit code identifies the industry in which the business operates. The IRS uses NAICS codes to classify businesses into industry groups, allowing it to compare reported income and expenses with averages for similar businesses. This comparison helps identify returns that deviate significantly from industry norms, which may indicate potential inaccuracies or misstatements.

For example, a business in the restaurant industry reporting unusually low food expenses relative to revenue may raise a red flag for further review. The use of NAICS codes ensures that businesses are compared to similar operations, making the audit selection process more precise.

The Role of the Statistics of Income Bulletin and Averages for Line Items

The IRS relies on its Statistics of Income (SOI) Bulletin and other data sets to establish averages and norms for specific line items, such as income, deductions, and credits, by income level, industry, and filing status. These statistics are derived from tax returns filed in prior years and provide benchmarks for what is typical for taxpayers with similar characteristics.

When a taxpayer’s reported amounts on specific line items, such as charitable deductions or business expenses, fall significantly outside these benchmarks relative to their income or adjusted gross income (AGI), it may indicate a potential misstatement. For example:
•Excessively high charitable contributions relative to AGI could prompt a review.
•Disproportionate business expenses for a small business compared to industry averages may trigger further scrutiny.

This statistical approach enables the IRS to efficiently target returns with the highest risk of error or noncompliance.