IRS Publication 556

What’s the DIF?

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I’ve mentioned (even as recently as yesterday) that the IRS has sophisticated processes to determine who needs to be audited. The algorithms are called DIF and UI DIF. While the IRS explains how and why it does what it does (Publication 556) , the actual formulae are never shared with anyone. Because they would be invitations to cheat- knowing how to tweak the numbers to avoid an audit.

IRS Publication 556

The computer scoring is based upon the Discriminant Inventory Function System (DIF). This algorithm develops a numeric score for each individual tax return submitted to the IRS. (It is also used on some corporate tax returns.) If your DIF number is high enough, you can bet you will not only get notified of an audit, but you will have a tax bill (including penalties and interest) to pay.

The DIF takes into account all the schedules included on the tax return. And, there are different DIF scores used for each scenario. Obviously, if you list a tax shelter on your tax return, your score increases. Or, if you manage to donate a ton of money to charities, significant totals on Form 8829 (home office deductions), insane entertainment expenses, large travel costs, or outrageous car deductions, you can bet your tax return will be flagged.

But, a high DIF alone won’t get your audited. Because, like some of our clients who have business interests around the globe which means high travel expenditures, the return is manually examined and the data is examined. (Now, you know why we always have additional schedules that detail each cost component on your tax returns.)

There’s also that other too- the UI DIF, which is an abbreviation for Unreported Income Discriminant Index Formula. This is used to discern the probability that income was omitted on a tax return- or that there was inaccurate information included on the form.
Someone who only has one W-2 and files a 1040-EZ is not likely to be audited. But, someone who files a 1040 with a schedule C and no documentation for the items on that specific schedule- well, that’s a horse of a different color.

Which brings up some “no-brainers”- taxpayer situations that will incur more audits than not. For example, high income, high risk taxpayers (those who file complicated tax returns, with pass-through entities, tax shelters, trusts, etc.) are high up on the audit trail.

Another “no-brainer”? Some ding-dong who has significant earnings (1099, W-2) and has not filed a tax return. (Really? Yes, really- there are more of these folks than you would expect.) And, the IRS gets their attention in a hurry by computing a “Substitute for Return” (SFR) – one that entails a significant tax due. Nothing like a bill for $ 50K or $ 100K to get these folks’ attention.

And, now we get to the more interesting audits. Those folks who report significant amounts of itemized deductions. Their Schedule A forms list high charity, tax deductions, etc. And, the IRS begins to smell fraud- or errors in calculations due to the large number of deductions listed.

Finally, we get to yesterday’s topic. Those who have unincorporated businesses, the self-employed folks. We already found that many of these folks simply cheat (or is that complexly cheat?), invent deductions, or fail to include all income- especially when they receive that revenue in cash or don’t get a 1099 that includes those receipts.

Consider yourself educated. (Or, is that warned?)

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5 thoughts on “What’s the DIF?”

  1. Thank you for sharing this info. As an artist the IRS sees me as self-employed, event though as of yet I haven’t actually turned a profit after expenses. I’ve wondered if I’d ever be audited for filing forms that show my business expenses exceed my business income. This year though, I don’t expect that to be the case, I think I may actually turn a small profit for once.

    1. Vicki…
      That is one of the biggest issues artist face. The law (yes, it’s true) demands you make a profit 3 years out of every five. The IRS can declare your business a hobby and disallow all losses that could be used to offset other revenue. If there is no other revenue, they will question who is supporting you…since it is impossible to continue to lose money without having a source for replenishment.

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