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One of the major stressors at tax time is wondering whether you've made a mistake on your return that might come back to haunt you years later. You can take some comfort in the fact that the Internal Revenue Service only audits about 1 percent of all tax returns each year. A statute of limitations exists regarding how far back they can go. The bad news is that the IRS can audit you every year if it thinks it has cause – and if it thinks it has cause, it probably will.
The process of double checking a tax return begins with a trigger, and this trigger is often the Discriminant Function System, also called DIF. It's an IRS computer program that screens your return, looking for anomalies by comparing your information against the returns of other taxpayers who bear some similarity to you. Their earnings might fall into the same income range or they might live in the same zip code. If your return includes some radically different information, DIF will give it a high score, indicating that there's a potential for unreported or untaxed income. Examiners typically scrutinize paper returns – as opposed to electronically filed returns – when they arrive at IRS regional centers, and they also look for glaring inconsistencies. The IRS compares your claimed income against W-2s, 1099s and other tax documents it has received from businesses under your Social Security number to make sure your statement of what you earned matches the records of what these entities say they have paid you.
Having your return flagged is not an automatic kiss of death. It just means the IRS is going to review it a little more closely. If DIF labels your return with a high score, it goes to an auditor. The auditor might decide everything's fine, but if he doesn't, he passes your return to an examining group. The manager of the group double-checks your return and determines whether or not to subject it to an audit. If he thinks more investigation is required, your return goes back to an auditor who now has the final say as to whether to initiate an audit. The audit itself can be as simple as some correspondence asking you to substantiate certain information included in your return. You might just get a bill for additional taxes due, or you might be subjected to a full-blown audit, depending on the severity of your error.
Statute of Limitations
By law, the IRS doesn't have forever to get around to double checking your return, but exceptions exist. Under normal circumstances, it has three years. The clock begins ticking with the date you filed your return or that year's due date – usually April 15 – whichever is later. If you failed to report or underreported income and the difference is 25 percent or more, the IRS has an additional three years to audit you. The IRS says it tries to initiate actual audits within two years. If the IRS decides – and can prove – that your mistake was fraudulent in nature, there's no statute of limitations. It can go back as many years as it likes to look at your previous returns.
The law doesn't allow the IRS to audit the same tax return more than once – but an actual audit must take place for this double jeopardy rule to apply. You must receive a final findings report from the auditor, closing your case. If your return is flagged, double-checked, but no audit is ordered, you're not out of the woods because a simple in-house review doesn't count. If a subsequent year's return is audited and the IRS has reason to believe your previous returns might share the same error, they can go back the statutory three years – or indefinitely if fraud is involved. Technically, the IRS can audit every one of your returns if it wants to, year after year, unless it has actually audited one of those returns before.
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