Managing tax audits using sampling techniques
Sampling is a tool that is generally used whenever there is a list of records, also known as the population, that requires an assessment in order for the taxpayer to categorize the costs in a correct manner. Taxpayers use sampling to estimate the total amount of taxable transactions, meals deductions, expenditures qualifying for the Sec. 41 research credit (R&D credit), and several other applications.
The IRS and state taxing authorities typically use sampling to audit taxpayer determinations and estimate adjustments to amounts reported on tax returns. Sampling can produce efficiencies by reducing the volume of work and time required to make the necessary determinations required for tax filings or audits of tax fillings.
The two types of sampling: Statistical and judgmental
The two types of sampling used across tax audits are statistical (random) sampling and judgmental (nonrandom) sampling.
A statistical sample gives each record in the population a known, nonzero chance of selection. This allows for an unbiased sample selection and an unbiased representation of the population. Moreover, the examiner can make mathematically defensible conclusions about the population and the accuracy of the estimates.
A judgmental (nonrandom) sample is based entirely on the examiner’s judgment. For example, the examiner may pick the sample based on prior research and knowledge of problematic areas. While this can be efficient for finding issues, it causes gross bias when extrapolating sample results to make conclusions about the population. Even when the examiner attempts to select the sample haphazardly in an effort to judgmentally choose a random assortment, there is a human tendency to select a sample that is not representative of the population, and therefore judgmental samples risk a skewed calculation of adjustments, disallowed amounts, or even penalties and fines.