Slightly more than one million taxpayers faced an Internal Revenue Service (IRS) audit of their individual tax return in 2017, but that accounted for less than 1%of all returns.
If you do receive a dreaded audit letter from the IRS, stay calm and understand that the analysis is a professional procedure that may be resolved by simply presenting the correct paperwork.
Knowing what to expect can assist you in promptly addressing errors, handling numerical discrepancies, communicating respectfully with IRS agents and completing the process with only a moderate level of stress.
Why the IRS May Contact You
Taxpayers should understand that an audit in no way implies suspicion of criminal activity. Tax returns are complicated documents carrying financial data that must be evaluated to confirm accuracy.
The audit process is known as an examination and does not imply that you have intentionally made an error. In fact, the IRS contacts individuals for a variety of reasons.
Taxpayers are chosen through a “random selection and computer screening” process, according to the IRS, that is based on a statistical formula. The IRS compares tax returns against “norms” for similar returns. If your return doesn’t follow the “norms” you may be chosen for an audit.
If your tax filing includes transactions with other taxpayers, such as business partners or investors, and they were audited, you also may be audited.
Some returns are chosen based on other factors like income reported or unusual deductions.
Other reasons you may be audited:
- Conflicting third-party reports regarding income on 1099s or W-2s
- Home office deductions
- Rental losses
- Business use of a vehicle
- Hobby-related deductions (also known as hobby losses)
- Foreign currency transactions or bank accounts
Three Types of Audits
Depending on the level of severity, there are three types of audits. Most audits are nothing serious, and more than three-quarters of audits are completed through the mail, according to news reports.
- Correspondence (Mail) Audit – Routine errors from incorrect math or missing paperwork are often handled through correspondence.
- Office Examination Audit – An office examination is scheduled at a local IRS branch where they will generally try to find out if you reported all of your income and that your deductions are legitimate.
- Field Audit – A field audit is the most extensive of the three. An IRS agent will pay a visit to your home, business or accountant’s office to examine records and files in order to confirm that your tax return information is correct.
Preparing for an Audit
If you are being audited, the IRS will contact you by mail or telephone, not by email. Included in the notice will be the specific information that is to be examined and what supplementary documents you may need to present.
You have 30 days to respond to an audit notice. Do not put off your response, as the time you spend ignoring a letter can be time that interest builds on the amount you owe the IRS.
Before an audit, you need to get your paperwork ready, seek to understand what the problem is and determine if you want representation.
Gather the forms the IRS has requested. You will want to make sure you have copies, not originals. Organize your paperwork, and make sure the documents you have match up with the year that is under audit. If you realize you have misplaced certain records, immediately call and request that duplicates be sent to you.
Documents you may be asked to bring can include:
- Home mortgage statements
- Previous tax returns
- Brokerage statements
- Retirement account records
- Pay stubs
You may want to contact a tax professional to review your documents and make sure you understand what the discrepancy might be. If you completed your taxes at home using an online filing service or through a tax compilation company, the company may provide an audit defense service for a fee.
During the Appointment: Know Your Rights
For the actual appointment, you can attend by yourself or opt for representation to attend in your place or alongside you. It may be costly, but a certified public accountant (CPA), attorney or IRS Enrolled Agent or paid preparer of your return can represent you.
During the audit, which will take place in person at an IRS office or at your house, you should be polite and compliant. Only show the IRS agent documents that are specifically requested.
At the same time, you have rights and deserve fair treatment. Here are your taxpayer rights during the audit process, according to the IRS:
- A right to professional and courteous treatment by IRS employees.
- A right to privacy and confidentiality about tax matters.
- A right to know why the IRS is asking for information, how the IRS will use it and what will happen if the requested information is not provided.
- A right to representation, by oneself or an authorized representative.
- A right to appeal disagreements, both within the IRS and before the courts.
After the Audit
An IRS audit may end with no changes, an agreed-upon change or changes that the taxpayer disagrees with and appeals.
After the interview, the examiner will present you with a computer-generated audit report, which will include the amount of additional tax that is assessed, an explanation of how your return will be changed, options for how you can appeal the report and a space that indicates whether you consent or disagree. Signing the report means you are giving up your right to go to Tax Court.
If you are unsure whether you agree with the report, you do not have to sign it. You can request to speak with the agent’s supervisor to review the documents further. You can appeal the decision after this, request assistance from the Taxpayer Advocate Service and go to court if necessary.
Any tax deficiency will accumulate interest at a rate of 5% per year from the date of the original return until you pay the bill. The interest is compounded daily. The IRS examiner will often have this information prepared, showing the total you owe.
Based on the type of errors discovered during the audit, you could also face a penalty of up to 25% of the deficiency, and, for severe cases, possible imprisonment.
What If I’m Unable to Pay?
Penalties and tax deficiencies can hike your tax bill to an unaffordable amount, but don’t worry, you can do one of three things.
- Get an extension: Call the phone number listed on the IRS bill and ask for a short-term extension, but only if you are able to pay in full within 120 days. If not, you’ll need a payment plan or an offer in compromise.
- Monthly payment plan: You can go to the IRS website and apply for a monthly payment agreement. Monthly dues can be set up as automatic payments from a debit account.
- Offer in Compromise: An offer in compromise is an agreement to settle the tax debt for less than the amount you owe. You’ll need to meet requirements such as proving financial hardship to be eligible.
Common Myths About Audits
TV shows and movies have created a myth about tax audits. Just the word audit strikes fear in a lot of people. However, they aren’t as dramatic as what you see on the screen. It’s a much more clinical process.
Some common misconceptions about tax audits are that they only go after the wealthy, certain deductions will trigger an audit and that professional tax preparers are audit-proof. These are overblown of course.
The IRS operates a lot like the TSA at the airport. Some returns are chosen at random, others are chosen because something looks like it might be out of the ordinary.
While it is true, statistically, that the higher your income, the more likely you are to be audited, there is still the possibility of an audit for those with lower incomes. Less than 1% of tax payers with under $500,000 in annual income were audited in 2017, but the IRS still audited .71% of returns filed by those who made under $25,000.
The percentage increases substantially if your annual income is over $1 million. Nearly 15% of tax payers that made over $10 million per year were audited.
Many times an audit won’t happen in the year you file. It could be two or even three years after, but none more. The statute of limitations for an audit by the IRS is three years.
Protect Yourself in Case of an Audit
Simply keeping all of your paperwork can prepare you for a possible audit.
Here are some basic steps to keep your records in order:
- Keep tax returns and records for three years.
- Save your checkbook registers.
- Organize receipts by date for major purchases.
- File bills in folders.
- Journal and keep evidence of deductible information.
- Keep tax documents in one location.
In addition to knowing where all of your documents are, take the initiative to compare your tax liability to the national average in your occupation. Having an idea of how much you should pay in taxes can guide you in evaluating if your taxes are properly complied. Sometimes double-checking for accuracy can help you avoid a lengthy, and sometimes costly, process.