How AI Could Flag Your Tax Return for an Audit: What You Need to Know to Stay Safe

06-07-2024


June 7, 2024

 

The Internal Revenue Service (IRS) is adopting artificial intelligence (AI) to enhance its tax return auditing process, aiming to reduce the tax gap. Consistent and transparent use of this technology is essential, according to a recent report from the Government Accountability Office (GAO).  Click here for the report that was released last week.

Tackling the Tax Gap

This GAO report revealed that from 2014 to 2016, taxpayers voluntarily paid 85% of the taxes owed on time. The remaining 15%, approximately $496 billion, constituted the “tax gap,” primarily due to underreported taxes. To address this, the IRS audits a random sample of tax returns, focusing on certain characteristics, such as self-employment status.

The IRS has recently piloted an AI-based method for selecting taxpayers for audits. However, key components and technical specifications of this AI have not been documented. The GAO recommends that the IRS document these elements to ensure consistency and transparency in AI usage.

Implementing AI for Efficient Audits

The report highlights that the IRS is integrating AI models to improve audit selection efficiency under its National Research Program (NRP). Proper documentation of these AI models is crucial for clear communication and assessment of model components, technical specifications, updates, and performance.

The IRS uses a statistical technique on NRP audit data to account for undetected noncompliance, nearly doubling the estimated tax gap from $145 billion to $278 billion. However, the IRS has not analyzed the causes of this undetected noncompliance. Conducting such an analysis could enhance the reliability of these estimates and improve examiners’ detection capabilities.

Enhancing Documentation and Transparency

The IRS is piloting a new AI-driven process for selecting tax returns for NRP audits, aimed at improving efficiency and identifying noncompliance. Yet, documentation for several AI model elements, including key components and technical specifications, is incomplete. Completing this documentation will help retain organizational knowledge, ensure consistent model implementation, and increase transparency for future users.

Strategic Operating Plan and Audits

The IRS plans to increase audits of large corporations, partnerships, and wealthy individuals , funded by the Inflation Reduction Act. However, the GAO noted that this plan is not clearly linked to tax gap data and does not address significant areas of noncompliance, such as those involving sole proprietors.

GAO Recommendations

The GAO made six recommendations to the IRS, including conducting additional analyses to understand undetected noncompliance causes and completing documentation for the AI sampling process. The IRS agreed with these recommendations and outlined steps to implement them.

Melanie Krause, IRS chief operating officer, emphasized the importance of improving technical documentation and formally documenting analyst and management decisions in response to the GAO report.

AI’s Role in IRS Efficiency

Eric Hylton, former commissioner of the IRS’s Small Business/Self-Employed division, supports the use of AI and machine learning to enhance IRS efficiency. Quality control over input data is essential to ensure AI effectiveness. AI can streamline processes, such as predicting successful prosecution referrals and saving time in audits.

Despite potential challenges, such as “hallucinations” in AI, Hylton believes AI can significantly aid the IRS, particularly in reducing error rates and improving noncompliance detection.

How To Stay Safe

  1. Double-Check Your Information: Ensure all the information you provide is accurate and complete. Double-check for any mistakes or omissions that could raise red flags.
  2. Maintain Detailed Records: Keep thorough records of all income, deductions, and credits. Organized documentation will support your claims if an audit occurs.
  3. Report All Income: Make sure to report all sources of income, including side gigs and freelance work . Underreporting income is a common trigger for audits.
  4. Avoid Round Numbers: Use precise figures instead of rounded numbers, as round numbers can look suspicious and attract scrutiny.
  5. Understand Deductions and Credits: Familiarize yourself with allowable deductions and credits, and ensure you have the necessary documentation to back them up.
  6. Stay Updated on Tax Laws: Tax laws change frequently. Keep informed about the latest regulations to ensure compliance.
  7. Consider Professional Help: Most everyone needs a CPA. Consider hiring a professional tax preparer or accountant who can help you navigate the process and avoid potential pitfalls.