The Internal Revenue Service reported that it expected to process more than 140 million tax returns by the end of May 2020. That’s a lot of figures and numbers that require some scrutiny. So how does the IRS confirm that each and every one of those returns is accurate? With the help of a computer, of course.
The Discriminant Function System
The IRS computer is called the discriminant function system, and it’s not just one system but rather three, all working together. Tax returns pass under the system's watchful eye as they're received, and it assigns each a score. The higher the score a return gets, the more likely it becomes that the IRS might be able to collect a few more tax dollars if it takes a second look at it.
One or two small isolated mistakes aren't likely to land you in a lot of hot water because the scores are the result of numerous factors picked up by all three computer components and they’re all taken into consideration together. But if a tax return has a lot of anomalies when it’s compared to those of other taxpayers in similar financial circumstances, it will probably earn a high score and it will typically be assigned to an IRS employee for further human review.
This might result in an audit. Only an employee can instigate an audit and this involves a bit of a process. The discriminant function system can’t launch an audit on its own.
How Does the IRS Verify Income?
One of the computer components – the unreported income discriminant function system – specifically gauges the likelihood of certain types of unreported income on a tax return. This isn't earned income received from an employer, but rather, that which comes from other sources, such as investments and self-employment income.
Will it zero in on that one little job an independent contractor took on in exchange for a cash payment and promptly forgot about? Not likely. But it will pick up on discrepancies between information returns received by the IRS – all those various 1099s that must be submitted by banks, brokerages firms and anyone who remits more than $600 to an independent contractor – and what the taxpayer with that Social Security number actually reports on his return.
How Does the IRS Verify a W-2?
The discriminant function system will also sniff out discrepancies in reported employee income. Employers must issue employees W-2 forms at year’s end showing just how much they earned and how much was withheld from their paychecks for various taxes. And those employers must send a copy of each W-2 to the IRS as well. So you can pretty much rest assured that if you received a paycheck during the course of the year, the IRS knows about it.
The Protecting Americans from Tax Hikes Act (PATH) of 2015 moved up the date by which employers must submit their W-2s to the government, giving the IRS a little more time to compare them to employees’ tax returns. So does the IRS check every W-2? Yes, pretty much.
Important W-2 Changes
In fact, the IRS made a change to some W-2 forms beginning with the 2017 filing season to help with this verification process of crosschecking income reported on tax returns against income paid to the same taxpayer and reported on a W-2. If you work for a large company and it uses a payroll service provider, you might notice a 16-character verification code in box 9 of your W-2.
The IRS would like you to include this number with your tax return if you e-file to make its job a little easier. It promises that if you do so, this will speed up the processing of your return, although how much it will speed things up is unclear. Technically, the number is supposed to verify that a W-2 is “authentic,” but it also provides an easier way to compare W-2s to tax returns in addition to an employee’s Social Security number.
With or without that verification number, the IRS now matches a tax return’s income information against a taxpayer’s W-2 or W-2s before it issues a tax refund. If the information doesn’t match up, the taxpayer can expect to receive a notice from the IRS asking why, rather than cash back for overpaid taxes or a refundable tax credit.
Other Red Flags
Of course, unreported income isn’t the only potential problem with tax returns. The IRS does a lot of other verifying and checking as well, and it relies on a variety of tips so it knows when to take a closer look at a particular taxpayer even if the discriminant function system doesn’t wave a red flag.
Your tax return might be singled out for further review if you haven’t done a single thing wrong. If someone who paid you money did do something wrong, your return might be pulled into the fray by association. This happens most often with business partners, investors and independent contractors, but it could also happen if your employer is suspected of doing something wrong and all you did was accept a paycheck.
Then there are those “John Doe” summonses. These can be particularly tricky because the individual taxpayers affected by them might not even know about them.
Tax Avoidance Scams
IRS radar for detecting tax avoidance scams is particularly fine-tuned. The agency regularly looks into companies who offer or promote any type of service that even hints of avoiding payment of taxes. It will issue these summonses to various businesses such as credit card companies who work with or contract with the company, It will demand a complete list of any consumers who have enlisted the company's services or paid them money, as well as associated records.
Taxpayers whose names appear on these lists can expect that the IRS will take a closer look at their tax returns to ensure that they weren’t successful in dodging any taxes due.
The discriminant function system will also pick up on a few other seemingly innocent factors. Rounded-off numbers on your tax return can make the computer wave a flag. In all likelihood, an employer did not pay you exactly $18,000 and your side gig didn’t give you exactly $22,000. It was probably more like $18,290 and $22,990. The discriminant function system might indicate that these numbers should be checked against various W-2s and 1099s to determine what the numbers really were because the rounded numbers are probably not correct.
Deductions and Tax Credits
Most taxpayers who earn $60,000 a year don’t donate $30,000 to a qualified charity and claim a tax deduction for that amount. They might give away a few thousand if they’re particularly generous and altruistic, but they’re probably not going to donate half their earnings. The discriminant function system will raise an eyebrow over this type of issue as well.
And you’ll certainly hear from the IRS about the problem if both you and your ex-spouse claim your child as a dependent for a tax credit, although this might be a perfectly innocent mistake, the result of a lack of communication. The discriminant function system checks the Social Security numbers of all those claimed as dependents to make sure that the same individual doesn’t turn up on more than one tax return.
How Much Income Did You Have?
Let’s face it – the IRS is more likely to be able to collect additional tax dollars from someone who earns six figures annually than it is from someone scraping by on $20,000 a year. High incomes can warrant a closer look by an IRS employee.
Then again, if your reported income dropped from $250,000 last year to $25,000 this year, the IRS might decide to take a closer look at this situation as well. The same applies if most people in your profession earn $100,000 a year but you’re claiming you made just $50,000. The discriminant function system might want a human employee to find out why, particularly if it’s not your first year in business.
How Many Years Can the IRS Go Back for an Audit?
So how long do you have to sweat it out, worrying about whether the IRS will zero in on a mistake you might have made? Three years is the basic statute of limitations for a potential audit. A variety of factors can extend this to six years, however, such as if your reported income is more than 25 percent off from what it actually was for that year.
How Does the IRS Contact Taxpayers?
You can pretty much count on one thing if the IRS decides to take a closer look at your tax return because it couldn’t confirm some information: an IRS agent will not pick up the phone and call you, at least not out of the blue without making some other form of contact first. If someone does call you claiming to be with the IRS, it’s likely to be a scam if this is the first you've heard about there being a problem.
The fact is that IRS is a big fan of the good old United States Postal Service. All its contacts with taxpayers are initially made by regular postal mail. The agency won’t email you.
This isn’t to say that you might not receive a phone call or even a visit from the IRS at a later point in time, but phone calls are typically follow-up contacts after a notice has been sent to you. And the IRS certainly won’t ring your doorbell unless the matter is particularly serious or it amounts to a pretty significant amount of money.
Beware of IRS Impersonators
Even if the IRS does call you after sending a notice, it will not ever tell you how you should make payment for any additional tax due because you made a mistake on your return. A bona fide agent won't take a debit card number or a credit card number from you over the phone, and it certainly won’t tell you to go buy a gift card in a certain amount and send the card to a certain address.
As for that person ringing your doorbell telling you that he’s from the IRS, odds are that he’s not the real deal, either. If he is, he should have two forms of ID saying so, something called a pocket commission as well as a HSPD-12 card. You have a right to ask for these forms of ID and you can feel free to close the door if you don’t get them. And this isn’t even to mention that you’ve probably been expecting him for a while because the IRS has been repeatedly reaching out to you about a certain very serious problem.
If you’re hearing this news a little too late – someone pretending to be from the IRS has already reached out to you – you can contact the IRS at 800-366-4484 to report a phone scam or at firstname.lastname@example.org if you’ve received a questionable email. As for that guy standing at your door without two forms of ID, you might want to call the police.
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Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.