This is one story the Internal Revenue Service would like buried! Since the IRS views its relationship to taxpayers as an adversarial one, it tries to keep its battle tactics secret from its enemies (i.e., all of us).
Today, we’re going to expose one of the IRS’s secrets and arm you with the knowledge you need to defeat it.
The IRS has methods for recognizing potentially unrealistic dollar amounts reported on tax returns. Besides identifying figures that seem too small or too large relative to the range they “should” fall within given other tax data, the IRS can finger returns for audits based on whether the first digits of any dollar amounts reported are represented in accordance with statistical norms.
If a business owner decides to falsify or “roughly estimate” sales and expenses on a tax return (which we would never recommend), chances are the person will be savvy enough to avoid round-number dollar amounts and will attempt to randomly vary the digits used so that the figures appear to be realistic. However, IRS bureaucrats have computer programs that can actually detect when taxpayers are attempting to put random numbers on their returns.
You Won’t Find This in Any IRS Publication
Intended for Taxpayer Eyes
Being able to differentiate made-up randomness from real-world randomness does not require mind-reading or lie-detector tests. Instead, the IRS uses a mathematical principle known as Benford’s Law – and counts on most taxpayers being totally ignorant of it.
Benford’s Law states that in tallying up virtually anything – from populations of cities, to the value of the S&P 500, to tax write-offs – the first digit is most likely to be a “1” and is steadily less likely to be a higher digit, and that “9” is the least likely to be the first digit. This holds true whether we’re talking about something that’s measured in terms of hundreds, thousands, millions, or billions.
Benford’s Law may at first seem counterintuitive. But there’s a perfectly logical reason for why it works, as the following example will illustrate:
Say you bought a stock at $10. It would have to double to become a $20 stock. But once it hits $20, it only needs to gain 50% to become a $30 stock. At $90, it would only need to rise 11.1% to get to $100. And at $100, Benford’s Law starts all over again – the stock would need to double to get to $200, etc. So given that it takes much more leg-work to move from $10 to $20 than it does to move from $80 to $90, the probabilities are that more stocks will at any given time be priced with a “1” or a “2” as a first digit than an “8” or a “9.”
This principle applies to just about everything that can be bought and sold in dollar terms – from land to labor to light bulbs. That’s why the IRS uses Benford’s Law to try to nab tax cheats as well as good-faith filers who are estimating because they do not have precise numbers.
Taxpayers Reporting False Data
Often Give Themselves Away:
A person who is “approximating” income and deduction data because he lost his records might assume that he’s less likely to get flagged for an audit if he varies the beginning digits so they are represented roughly equally. After all, if a return had six times as many entries beginning with a “1” as with an “8,” that could raise suspicions, right? Wrong, according to
Benford’s Law, which suggests that numbers beginning with “1” occur about 30% of the time while “8” numbers occur only 5% of the time.
When people are making up figures out of the blue they tend to want to treat each digit equally and, if anything, are more attracted to the middle digits (especially “5” and “6”). They give statistical short shrift to the first digits, and by doing so they may attract the attention of an IRS auditor.
for Detecting Issues with Your Tax Return
Are Becoming Advanced
Since IRS studies have found that figures reported on millions of tax returns do in the aggregate follow Benford’s Law closely, returns whose figures stand out as extreme outliers could be flagged for an audit. Of course, there can be legitimate reasons for a taxpayer’s figures to be skewed from the norm. So if you have written records to back up all your numbers, there’s no need to worry about Benford’s Law.
It would be senseless to input false data in the hope of reducing your audit chances. However, if you find you have an unusually large amount of deductions in the $500s-$900s, for example, then you might consider bunching some of them together where possible. So instead of deducting two pieces of a two-piece office desk separately at $522 each, you might treat the two pieces as a single unit and deduct $1044 (provided your accountant approves, of course).
Hopefully, you’ll never need to make entries on your 1040 based on Benford’s Law. But being aware of it could at some point come in handy and help save you from unwanted attention from the IRS.
One last point: It is one thing to show you how honest people who estimate numbers on their returns can place themselves in greater jeopardy of an audit. But we do not in any way suggest that this inside knowledge of IRS operations will enable you to get away with fudging your numbers. Tax cheaters risk being slapped with civil penalties and are sometimes even prosecuted criminally.