Legal Definitions - discriminant function

The Discriminant Function, often referred to as the DIF system, is a sophisticated method used by the Internal Revenue Service (IRS) to identify tax returns that have a high likelihood of containing errors or discrepancies, making them candidates for an audit. This system operates in two main stages:

• A computer program analyzes submitted tax returns, assigning a numerical score based on various factors and patterns that historically indicate potential inaccuracies.
• Returns flagged with a high DIF score are then manually reviewed by an IRS examiner, who makes the final determination on whether an audit is warranted.

Here are some examples illustrating how the Discriminant Function might apply:

• Example 1: Unexplained Fluctuations in Financial Patterns

  Imagine a taxpayer who has consistently reported a stable income and standard deductions for many years. Suddenly, in the most recent tax year, their return shows a significantly lower reported income coupled with a substantial increase in business losses from a newly established, vaguely described venture. The DIF system would likely flag this return. It is designed to detect unusual deviations from a taxpayer's historical filing patterns, as drastic shifts in financial reporting without clear, documented life events (like retirement or a major career change) can signal potential errors or misrepresentations that warrant closer examination.

• Example 2: Expenses Significantly Outside Industry Norms

  Consider a self-employed consultant who reports that 70% of their gross income was spent on "office supplies and equipment," far exceeding the typical percentage for similar consulting businesses. The DIF system incorporates statistical data on average income, deductions, and expenses for various professions and industries. If a taxpayer's reported figures fall significantly outside these established norms without clear justification, the system flags it as a potential area of concern, indicating a higher probability of error or overly aggressive deduction claims.

• Example 3: Claims for High-Risk Credits or Deductions

  A taxpayer claims a substantial amount for the Earned Income Tax Credit (EITC) while also reporting complex self-employment income and multiple dependents, some of whom have ambiguous residency situations. The DIF system is programmed to pay closer attention to returns that combine these "high-risk" elements. Certain tax credits and deductions, like the EITC, are historically associated with higher rates of improper claims due to their complexity or specific eligibility requirements. When such claims are present, especially alongside other data points that might suggest inconsistencies, the system increases the likelihood of a manual review by an IRS examiner.