Multistate Income Tax

Appendix BAUDIT DEFENSE STRATEGIES¹

Introduction

Going through an audit is, under the best of circumstances, always an adversarial process, and not for the squeamish or weak of heart. The topics discussed here are not pretty. Nevertheless, taxpayers and their advisors will find it useful to learn how audits get chosen, what auditors look for before they arrive, what they want to see once they do show up, and what, if anything, can be done about it.

Audit selection

Several things may prompt state or city taxing authorities to select a particular business for audit. First, and probably most frequent, is some sort of statistical modeling (kind of like winning a lottery, but not nearly as much fun). At the federal level, the IRS has its infamous statistical program, the computerized discriminant function (DIF) technique. IRS selects returns for examination based on, for example, discrepancy with information returns, a history of deficiencies, random sampling, and the “questionable refund” program. Using DIF scores, IRS ranks and selects returns having the greatest audit potential. With the IRS approach as a guide, many states and cities have fashioned their own models.

Formulas and statistics

The process begins when taxpayers file their first sales tax or income tax return, and the data is entered, evaluated, and graded. Using formulas that everyone learned in college, but ...