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Statistical Profiling of Schedule C Audits

Amir Aczel is a statistics professor who profiled what kinds of returns get audited. He found that when a Schedule C shows deductions up to 52 percent of revenues it is usually not audited. "The critical zone is reached for Schedule C, he said, when expenses exceed 63 percent of revenues."

I found this statement astounding. A small business that has a *net margin* of 37% is an amazingly *profitable* business. As proof of that statement, consider a public company like Amazon - which most people would agree is a superstar company with a business moat that lets it achieve above average margins. In 2008 Amazon earned $645M against $19.1B in sales. That means that Amazon claimed more than 95% of sales as expenses (cost of goods, ordinary expenses, and other expenses). When I am examining companies as investments, and I find any company that can sustain more than

10% as a net margin after all expenses, I know I have something special. Most people would love to have a business that consistently earned even 20% of sales. At least among public corporations, the mediocre and average companies rarely sustain better than a 3% to 5% net margin.

How can it possibly be the case that the IRS would target small businesses that have the kinds of huge net margins Aczel is claiming?

Reply to
W
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According to some web sites referring to this guy, the ratio is expenses to "gross income". Gross income, on Schedule C, is gross revenue less cost of goods sold. So, with COGS out of the picture, the ratio may make some sense.

Reply to
Wallace

Where did you find this information? Is it from Aczel's book that was published 14 years ago? (How to Beat the I.R.S. at Its Own Game: Strategies to Avoid - and Fight - an Audit, Revised edition, December, 1995) If so, the statistics are probably irrelevant to any recent IRS audit activity.

And how did he get such a detailed breakdown of Schedule C revenue and expenses on audited returns?

Bob Sandler

Reply to
Bob Sandler

For that matter, where did Aczel get HIS information? Tax audits are not public record.

Reply to
Bill Brown

You're forgetting that for larger companies, the net margin is after payment of salaries, which can be the largest expense of many businesses. For solo schedule "C" filers, the net margin is calculated before deduction of the salary of the only employee.

Reply to
Stuart A. Bronstein

I read an article online. I have never read his book.

Why would the statistics have changed radically? For such a basic set of facts I think the IRS has set formulas and maybe they deviate by small percentages, but unlikely they change by orders of magnitude. Remember he isn't talking about tax laws, which change all the time. He is talking about proportions of certain kinds of expenses in typical businesses. For example, if you go all the way back to the 1950s and look at many kinds of public companies you find that the good ones have a return on equity around

12%. That number stays remarkably consistent over many decades. The basic DIF scoring that works so well for the IRS was created back in the 1980s and the IRS hasn't indicated any need to change those profiles. Sure they fine tune them.

He interviewed statistically significant numbers of individuals and businesses, determining which percentage had been audited, and which percentage of those showed common attributes. Statistics is an extremely powerful science in the hands of someone who understands its limits. Presumably as a statistics professor he was qualified for that task.

I'm not questioning the science. I just don't understand how the numbers he reported would be reasonable.

Reply to
W

That would be better but still gives an unreasonable result. Under your interpretation, Aczel is claiming that any business that keeps less than 37% of its gross profit (total revenue - cost of goods) as profit is suspect to the IRS.

Look at Amazon in 2008:

Gross Profit : $4.27B Operating Income: $842M // Note: I did not subtract interest expense, which does appear on Schedule C, so the result below overstates their profit % Operating Income as % of Gross Profit: 19.7%

Even under your revised interpretation, the only company I could quickly find that meets the IRS target for profitability is Microsoft (a monopolist)! Something has to be wrong with Aczel's numbers, or at least his interpretation of them.

Reply to
W

That's a great theory, although I would point out line 26 of Schedule C does let you capture wages for the business.

So your point is you think Aczel is only profiling small businesses with a single wage earner, who reports line 26 of Schedule C with $0?

You are right that would probably make the statistics much more reasonable.

Reply to
W

Then perhaps you should question the science.

Reply to
Bill Brown

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