Her Majesty, the Snoop

1/21/2013

Getting audited by the IRS is rarely anyone's spot of tea – unless, of course, you're the auditor. But at least our IRS plays fair and uses your actual return to decide whether to audit you. Across the pond, that’s not always the case at Her Majesty's Revenue and Customs Service.
 

Here in the former colonies, the IRS uses statistical analysis as their primary enforcement strategy. Every return gets a super-secret score called a Discriminant Information Function, or DIF, to look for oddities or discrepancies in your tax return. The higher your DIF, the more potential the IRS sees for bringing in additional taxes in an audit. Generally, small businesses organized as sole proprietorships face the greatest chance of audit – as high as 4% or more – because they have the greatest opportunity to underreport income and overstate deductions.
 

But back in the old country, HMRC is getting a little more aggressive. They're not just looking at tax returns – they've just announced a new program to use credit checks to find suspected tax cheats. The plan is to cross-check details of the income people report on their return against their actual spending in order to identify those at risk of both legal and illegal tax avoidance. Officials have just finished a pilot program involving 20,000 people and expect to expand it to as many as two million. Blimey!
 

The program sounds straightforward enough. Let's say you operate a pub in a small town somewhere outside London. You report £20,000 in income, but your credit file shows you spending closer to £30,000. Now the tax authorities have reason to believe you're not reporting all those pints of Boddingtons you've served – and they have actual evidence to make their case.
 

The problem, of course, comes when the program finds stashes of suspicious but legitimate assets. Let's say you're Robert Crawley, the 6th Earl of Grantham. Your own family money, which dated back to the Wars of the Roses, is long since gone. So you marry an American heiress. You make a genteel living managing Downton Abbey and occasionally sitting in Parliament. But if HMRC reviews your credit file, they're likely to find spending way out of line with your stated income! You can explain it, of course, as part of your wife Cora's inheritance. But who wants to have to explain that sort of thing to the tax man, even if you are paying your fair share?
 

Of course, the program also raises enormous privacy concerns. It's fashionable to say that in today's internet age, privacy is a relic of the past. But it's also hard to see a program like that flying here in the United States, at least not without howls of protest.
 

Since the IRS is still relying on DIF to do the heavy lifting, it’s important to make sure you prepare your return correctly – and strategically. Tax planning is not just about paying the least amount of taxes at the time you file. It’s also about finding ways to minimize your risks of being audited. For more information about how the IRS selects taxpayers for audits, head to our Quick Tips.