Tax Audits
The IRS wants to see if you reported the right amount of taxes. They mainly focus on your income and any big or suspicious items on your return.
What’s an IRS Audit?
An IRS audit, or “examination” in IRS talk, happens when the IRS wants to check if your tax return is accurate. An IRS auditor, like a tax examiner or revenue agent, will review your records to make sure everything adds up. If they find errors on your tax return, they will propose an “adjustment” and provide you with the opportunity to agree or disagree. Once resolved, you may owe a tax bill. In fact, almost 90% of all IRS audits end in an additional tax bill.
Key Points About IRS Audits
- Goal: The IRS wants to see if you reported the right amount of taxes. They mainly focus on your income and any big or suspicious items on your return.
- Process: Audits follow rules called “deficiency procedures.” You get a chance to show proof and appeal any changes the IRS suggests before you have to pay.
- Selection: You might get audited if the IRS spots a mistake on your return, through a computer check, a specific IRS project, or if you’re linked to someone else’s audit.
- Types of audits: Audits can be done through mail (“correspondence” audit), at an IRS office (“desk” audit), or even at your home or business (called a “field” audit). The level of involvement varies, with in-person audits (office or field) being more detailed.
- Frequency: Most audits happen through mail, making up 77% of all audits. But field audits, done at your place, are more thorough and rare.
- Changes: In about 90% of audits, the IRS makes changes to your return resulting in additional taxes owed. In 30% of audits, the IRS proposes a penalty.
- Penalties: Audits can lead to serious consequences, including criminal charges for tax evasion. However, the most common penalty asserted in an audit is the accuracy penalty which adds 20% to the tax bill.
Background on IRS Audits
In 2023, the IRS conducted over 582,000 audits, with most (3 out of 4) being mail audits.
Surprisingly, the most common reason for audits is an error in qualifying or computing the Earned Income Tax Credit and other refundable credits. But refundable credit audits are not the most serious of IRS audits. The IRS can select any return for audit. Common issues for individuals include income, alimony deductions, and small business and rental property transactions. For larger businesses, the scope of the audit can get into accounting methods, related entity transactions, employment tax, and even pension plan issues.
Resolving audits usually can take anywhere from 2 to 18 months. The longest audits occur in field audits on the most complex taxpayers (wealthy, small business) and business entities. It is not uncommon for these audits to last well over a year.
How to Handle an Audit
- Mail audit response: Most mail audits are simple to resolve. The IRS will ask you to provide documentation and/or an explanation for a specific item on your return. You will need to send them copies of documents and provide explanations to support your tax return accuracy. The IRS will generally give you 30 days to respond, or they will proceed to assess their proposed adjustments. If the IRS proposes an adjustment, you can dispute it, along with any penalties, or agree to the adjustment. If you cannot come to an agreement with the tax examiner, you can request an appeal with the IRS Independent Office of Appeals.
- Office/Field audit: Office and field audits are more comprehensive and can take well over a year to complete. You will need to prepare for the audit, have an initial interview with the IRS tax compliance officer (office audit) or the revenue agent (field audit), provide requested documents, and work with the auditor to resolve issues. Again, an appeal can be requested if you do not agree with the TCO or agent’s findings.
- Appealing adjustments: If you disagree with the auditor, you should first request a conference with their manager to resolve the issue(s). If needed, appeal to the IRS Independent Office of Appeals. An appeal will add 4-12 months, on average to your audit time.
Steps to Resolve a Mail Audit
- Review the letter: Understand what’s being audited and the deadline for your response.
- Gather documents: Collect your tax records for the year in question.
- Prepare your response: Create a response for each item under audit, including supporting documents.
- Provide evidence: This includes supporting documents. If you’re missing documents, try to reconstruct them. Provide everything the IRS asks for.
- Send the response to the IRS: Send a complete response to the IRS before the deadline. Normally, you mail the response, but often the IRS provides you with a “Secure Messaging” link or a fax number to respond directly to the auditor.
- Review the IRS decision: Check if the IRS proposes any changes to your return. If you agree, sign and return the forms. If not, discuss it with the auditor and escalate it to their manager first to resolve any differences.
- Appeal disagreements: If you can’t reach an agreement, file an appeal within 30 days. You will work directly with the Appeals Officer on the resolution. If you do not agree with the Appeal, you can always petition the United States Tax Court to review your case before the tax is assessed. You must request all appeals timely. Failure to meet deadlines for appeal will result in lost appeal rights.
Steps to Resolve an Office or Field Audit
- Prepare: Gather documents and simulate the audit process. Do a mock audit, reconciling all incoming funds to taxable income and all audited expenses back to the book, invoices, and payments. Review tax years prior to and after the years under audit for any potential issues. Review any related returns, such as partner/shareholder returns, employment tax returns, and any other filed information returns (W-2s, 1099s) for accuracy. Contact the TCO/agent to find out the most important issue in the audit and complete a full analysis in preparation for the audit. Make sure you Google yourself and your business and review any social media and public information that may be discussed in the audit. In the end, be prepared to present that your tax return is accurate as filed.
- Initial interview: During this initial meeting with the auditor, you will answer questions and provide information about the taxpayer (individual, business, etc.) under audit. This interview can last 1-4 hours, and can comprehensively cover the taxpayer, related taxpayers and entities, and the taxpayer’s line of work and business. Based on the quality of information provided, the auditor will get an initial determination of areas that they will need to analyze closely in the audit.
- Issue development: The auditor decides which areas to focus on and may ask for more information. This is the longest stage of the audit process and will involve one or more Information Document Requests (IDRs or Forms 4564) that will request information to be provided. It is important to respond to the IRS in writing to avoid any confusion.
- Resolution: During the audit, the auditor will likely propose any issues/changes to the return as they are found. You will discuss proposed changes, provide additional information and/or explanations, and try to reach an agreement. The auditor will provide a final report of the proposed changes (Form 4549) along with an explanation of the changes (Form 886-A). If you cannot resolve the issues with the auditor, you can escalate to their manager, IRS Appeals, or – in limited cases – to the Courts.
Face to face audits can lead to large tax bills and long audit durations due to their complexity and comprehensiveness. It’s often best to have a tax professional on your side to guide you through the process.