As you have probably learned by now, the IRS is an organization that is heavily reliant on statistics. The Service only has a limited amount of resources and must therefore pursue only those avenues that are most effective for increasing tax revenue. Tax returns are a treasure trove of information though and the Service has become increasingly sophisticated at utilizing that information to make itself more effective. This is not just limited to individual taxpayers, but also groups of taxpayers who live in the same area or whom have similar jobs in similar industries. It collects enough statistical data to come up with median figures or ranges of where it expects taxpayers to be in certain categories and audits those who are outliers. For example, let’s say the median income for a household in Beverly Hills, California was $200,000 per resident. If you are a taxpayer that filed a tax return claiming only $50,000 in income, it would be safe to assume that you might attract the attention of the IRS.
Similarly, a taxpayer who made tens of thousands more than the median income in a given area would also likely arouse suspicion within the IRS. The same reasoning also holds true with taxpayers in similar industries. Plumbers making hundreds of thousands of dollars or CEOs pulling in just over minimum wage will also likely be subject to audit. Certain professions also carry higher audit risk than others. Audit Technique Guides published by the IRS can also provide some clues as to what the IRS views at professions with a higher proclivity for abuse (http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Audit-Techniques-Guides-(ATGs)).
The IRS also likely uses statistics to look for likely IRS audit red flags with businesses by comparing their margins. As an attorney, one of the first things that I look for when a small business owner approaches me about representing their business in an audit are what their margin percentages are.
Gross Margin Percentage = (Revenue – Cost of Goods Sold) / Revenue
Net Margin Percentage = Net Profit / Revenue
There is not necessarily a magic number for what your margins need to be. Every business is run differently and will have different margin percentages based on their annual revenue and their expenses. However, even though businesses will all vary on their margin percentages, margin percentages for a particular sector among similar businesses will largely be within a certain range. The IRS knows this and IRS audit red flags may be raised for businesses that are outliers, either with margins that are too low or too high. For your own edifice on what traditional margins are for your industry, there are many sources online that will tell you.
Let me show you how margins can work against you on your tax return. Say I own Convenience Store A. I file a tax return indicating that I made a 10% percent profit from the store after my expenses. No problem there. Now let’s say that Convenience Stores B, C, D, E, F, and G all file tax returns showing a 30-35% profit. That is quite a step up from 10% profit. There are several possible explanations here. I could be a bad businessperson. My revenue might be the same as these stores, but perhaps I am not keeping my expenses or my cost of goods sold in check. Consequently, I could have the same expenses and show less revenue because of a loss of business. Both of those are perfectly logical explanations. However, if I am not keeping up with my competitors, I am likely not going to stay in business for very long. I could also be skimming cash from the registers and underreporting income (decreasing my revenue) or inflating my cost of good sold (reducing taxable profit) or inflating my operating expenses (also reducing taxable profit). In contrast, if I start showing 75% profit, I am either the world’s greatest convenience store operator or there is a serious impropriety with my business.
My point is that you operate in the audit danger zone if you are outside the generally accepted range for businesses that are similar to yours. Tax cheaters will often try and bury deductions into other expense categories to not make them stand out or will make sure there is no paper record of them taking money out of the cash register. However, if they go too far outside the lines, it is probable that they will raise some IRS audit red flags and their margins that will eventually catch up to them.