I have seen expats concerned about the fact that since they don’t reside physically in the U.S. does that mean they are hiding something? Specifically, are they more likely to be audited? Before we take a closer look at the issue, let’s try to understand how the IRS selects returns for audit.
The IRS uses a variety of methods to select returns for an audit (they call it an “examination”). First, the IRS actively works to identify promoters and participants of fraudulent tax avoidance transactions. If the IRS receives information indicating that you may be a participant in such a transaction, your returns will likely be examined.
Second, the IRS uses a computer scoring system based on the information gathered from IRS research audits. The Discriminant Function System (DIF) score rates the potential for change and the Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income. The formulas that the IRS uses to calculate these scores are kept very confidential. Even people inside the IRS don’t know exactly how they are calculated. When you have an item on your return that is outside the normal boundaries, it’s flagged by the system and a person takes a look at it and determines whether or not it needs to be examined more closely.
A classic example is a return that shows very little income and a lot of interest and expense deductions. The IRS is going to want to know what that person is living on and the return will be subject to audit. The return could be totally legitimate—perhaps a person who recently lost a high-paying job is living off savings or has moved in with a family member, so he has virtually no day-to-day living expenses and is trying to meet his obligations from when he had a higher income. Or it could be that the person is in a cash business and is trying to avoid paying taxes by not reporting all of his income—in that case, the IRS is going to attempt to uncover the truth and take appropriate action.
Someone at the IRS will review the entire return and decide if the income and deductions look reasonable in the overall context of the return. If so, the taxpayer will never know his return was reviewed. If not, he’ll likely get a letter asking him to document the questionable items.
Returns may be selected for audit when they involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for examination. And some returns are identified for examination in connection with local compliance initiatives, specific market segments, or return preparers. Finally, some returns are selected for audit based on reports of suspected fraud. These reports are often made by former spouses, disgruntled employees, or someone you’ve ticked off for some apparent reason.
It’s possible that your tax return may be audited simply because of the tax preparer you used. If the IRS identifies a particular preparer as being routinely negligent or even fraudulent, it may cause them to look at every return that individual has prepared, and you may or may not be told that this is the reason you are being audited.
In any event, there is no indication that expats are a higher risk for audit. We certainly have not seen it in our business. Just be careful to review your return, make sure that your numbers agree with supporting documentation and there is no reason to believe that your chance of audit is any higher than any other U.S. citizen.