Explain how the discriminant function system works
Computer and manual methods are used to select returns for examination. Computer programs select certain returns for examination, based on the potential that exists for changes in the tax treatment of certain items on the return. Generally, this is done through the use of mathematical models, including correlations and discriminant functions.
Once a return has been processed through the IRS automated computer program, each return is rated by computer for its audit potential by means of a mathematical model, the discriminant function formula (DIF). This formula assigns numeric weights to certain (undisclosed by the IRS) return items, generating a composite score for the return. In this regard, the higher the DIF score, the greater the potential for additional tax payments upon audit. Statistics provided by the Commissioner show a high correlation between DIF scores and such tax modifications, but the specifics of the formula are not disclosed.
When the computer selects a return that has a high probability for an adjustment, as indicated by a high DIF score, an employee at the service center manually inspects the return to confirm its audit potential. If an acceptable explanation for the DIF score cannot be found after this manual examination of the return and its attachments, including explanatory data that the computer did not consider, the return is forwarded to the Examination Division at the appropriate local IRS office.