As a tax professional or business owner, it’s essential to understand the IRS audit process from both perspectives; the audited and the Tax Court representative.
An audit is a review of financial records to ensure that individuals and businesses are complying with tax laws.
When the IRS decides to audit, several factors come into play. Let’s break down the entire process, reasons, timelines, and types of records that may be requested.
This article aims to demystify the audit process and help you prepare for any potential scenarios.
What is an IRS Audit?
As I mentioned before, an IRS audit is a review or examination of an organization’s or individual’s accounts and financial data to ensure information is being reported correctly according to the tax laws and to verify the amount of tax reported is accurate.
Audits can result in three outcomes:
- No change (the IRS accepts the return as filed).
- A change in taxes owed (additional taxes are assessed).
- A refund (if overpayments are identified).
How Does the IRS Decide to Audit?
1. Random Selection: Sometimes, an audit is simply random, where returns are selected based on statistical formulas that flag certain discrepancies or unusual patterns.
2. Red Flags in Tax Returns: The IRS employs a system known as the Discriminant Information Function (DIF) to scan tax returns for anomalies. A DIF score compares your return to others in similar situations, flagging those that deviate significantly.
3. Related Examinations: If you’re involved in a business or partnership that’s being audited, or if a business you’re connected with is audited, your own tax returns could also be flagged for review.
4. Third-Party Reporting: Mismatches between reported income (e.g., from W-2s, 1099s) and what you declared in your tax return can trigger an audit.
5. High Deductions or Losses: Large deductions, particularly related to home office claims, travel, or entertainment, often raise IRS concerns, particularly if they are not proportionate to the income being declared.
The Audit Process Chronology
1. Notification: The IRS will send a letter informing you of the audit. You will never receive an initial audit notification by phone or email. The letter will specify whether the audit will be done by mail or in person.
2. Initial Review: The IRS agent begins by reviewing your filed tax returns and the records you provided.
3. Record Request: The agent may ask for additional documentation such as receipts, expense logs, bank statements, or contracts to substantiate the claims made on your return.
This phase can take weeks to months, depending on the complexity of your case.
4. Audit Meeting (if in-person): For in-person audits, you’ll meet with the IRS agent, possibly with your tax representative or attorney. These meetings are your opportunity to explain or clarify discrepancies.
5. Audit Conclusion: After reviewing your documentation, the IRS will conclude whether your return stands as filed, if adjustments are required, or if you owe additional taxes.
6. Appeals or Tax Court: If you disagree with the outcome of the audit, you can appeal within the IRS or take your case to the U.S. Tax Court.
At this point, having a SMAART Tax Attorney or a SMAART Enrolled Agent is highly recommended.
Records the IRS May Request
- Tax Returns: Copies of the returns under review.
- Bank Statements: To verify income and expense claims.
- Receipts: Particularly for deductions related to business expenses, charitable donations, or large purchases.
- Contracts and Agreements: If you are self-employed, this includes contracts with clients and customers.
- Travel Logs: For claims on business-related travel expenses.
- Payroll Records: If you’re running a business with employees.
- Investment Statements: To verify capital gains or losses.
The specific records requested will depend on the items flagged in your tax return.
Reasons for an IRS Audit
1. Income Mismatch: If the income you reported doesn’t match what was reported to the IRS by your employer or clients, this is a major red flag.
2. Excessive Deductions: For example, large charitable donations that don’t match your income level, or unusually high deductions for business expenses.
3. Self-Employment: Freelancers, gig workers, and small business owners tend to attract more scrutiny, particularly around deductions and income reporting.
4. Foreign Accounts: Failure to disclose foreign income or bank accounts can lead to an audit.
5. Unreported Income: Cash-heavy businesses (restaurants, retail) are more frequently audited due to the higher likelihood of underreported income.
Time Frames for IRS Audits
- Three-Year Window: In most cases, the IRS can audit returns filed within the last three years. If significant errors (like underreported income) are discovered, this window can extend up to six years.
- Immediate Action: Once notified, you typically have 30 days to respond to the initial request for information.
- Audit Duration: The length of the audit process varies based on complexity, from a few months to over a year in more complicated cases. Audits by mail are generally quicker than in-person audits.
NOW! Let’s see things FROM THE PERSPECTIVE of the Audited
From the taxpayer’s viewpoint, receiving an audit notification can be alarming. Preparation is crucial.
You see, in situations like this, some of you can do this for yourself, but having a professional by your side that operates with the most sophisticated accounting sofware available is priceless.
- Organize Your Documents: Keep accurate records of income, expenses, and deductions for at least six years.
- Consult a Tax Professional, of course. Engaging a SMAART Tax Attorney or a SMAART Enrolled Agent early can make the audit process smoother.
- Understand Your Rights: You have the right to representation, to appeal, and to understand exactly why the IRS is questioning your return.
Now, Let’s see things FROM THE PERSPECTIVE of the Tax Court Representative
For those representing taxpayers, knowledge of tax law is essential.
The representative’s goal is to:
- Provide Clarity and Defense: Your role is to ensure the IRS understands the taxpayer’s situation, especially where discrepancies are a result of honest mistakes or misunderstood tax laws.
- Negotiate Settlements: Often, you can help reduce the taxpayer’s liabilities by clarifying misunderstandings or negotiating with the IRS on certain deductions.
- Appeal When Necessary: If the audit results are unfavorable, you may appeal within the IRS or escalate the case to Tax Court. Legal strategies like presenting additional evidence or contesting the IRS’s interpretation of the tax code are key at this stage.
NOW, HOW to AVOID Being Audited by the IRS?
While there is no foolproof way to guarantee that you won’t be audited by the IRS, there are several practical steps you can take to reduce your chances of being flagged for an audit. These strategies focus on ensuring your tax returns are accurate, complete, and free from red flags that typically attract IRS attention.
1. Report All Income Accurately
The most common reason for an audit is underreported income. The IRS receives income reports from employers, financial institutions, and other third parties (W-2s, 1099s, etc.). If your tax return doesn’t match these reports, it raises a red flag.
To avoid these red flags:
• Ensure all forms are reported: Carefully review your tax forms (W-2, 1099, K-1, etc.) and ensure you report all income sources.
• Include side gig income: Income from freelancing, rental properties, and online sales must also be declared.
2. Be Cautious with Large Deductions
Deductions, particularly if they seem disproportionate to your income, can trigger scrutiny. While it’s important to claim all valid deductions, overly aggressive deductions (or fictions) may invite a closer look.
• Business Expenses: If you’re self-employed or running a business, ensure that deductions for travel, meals, and home offices are reasonable and supported with proper documentation.
• Charitable Contributions: Donations that seem unusually high compared to your income can raise suspicion. Be sure to keep receipts and detailed records of all charitable donations.
3. Avoid Claiming 100% Business Use for Vehicles
Claiming that a vehicle is used exclusively for business purposes is a red flag for the IRS, especially if it seems unlikely. If you claim this, maintain:
• Mileage logs: Keep a detailed record of your business and personal mileage.
• Receipts: Save receipts for fuel and vehicle-related expenses.
4. Please, PLEASE File Your Taxes On Time
Late filings are more likely to attract attention, and penalties can be substantial. Make sure to:
• File by the deadline: If you can’t meet the deadline, request an extension to file later, but remember that you still need to pay any owed taxes on time.
5. DOUBLE-CHECK WITH A PROFESSIONAL Your Math and Information
Simple math errors or missing information can result in automatic scrutiny. Avoid this by:
• Reviewing your return carefully: Double-check all calculations and ensure that every form is complete before filing.
• Using tax software or professionals: Tax software programs help catch simple errors and discrepancies. Better yet, consider hiring a tax professional who understands complex tax codes.
6. BE NOEST with Tax Credits
The IRS closely monitors certain tax credits due to their high potential for abuse. These include:
• Earned Income Tax Credit (EITC): If you claim this credit, ensure that all qualifying information is accurate and well-documented.
• Education Credits: If you’re claiming education credits like the American Opportunity Credit or Lifetime Learning Credit, be sure to maintain tuition payment records, student loan statements, and other supporting documents.
7. Keep Your Documentation in Order
Even if you are selected for an audit, being well-organized can make the process smooth and less stressful. Save all relevant documents, such as:
• Receipts for major purchases
• Bank statements that verify income and expenses.
• Contracts and agreements related to business operations.
8. Be Careful with Home Office Deductions
The home office deduction is another area the IRS scrutinizes, especially if you’re claiming a large portion of your residence as an office. To avoid triggering an audit:
• Ensure exclusivity: The space must be used solely for business purposes.
• Measure accurately: Calculate the square footage correctly and document its use.
9. Avoid Amending Returns Unless Necessary
While sometimes necessary, amending your return (by filing a Form 1040X) can increase the likelihood of an audit. If you make amendments:
• Ensure accuracy: Make sure the corrected return is completely accurate to avoid additional scrutiny.
• Provide detailed explanations: Include clear, concise reasons for the changes in your amended return.
10. Maintain Consistency Across Years
Consistency in reporting is important. For example, if your income spikes suddenly or deductions fluctuate dramatically from one year to the next, the IRS may take a closer look:
• Provide explanations if needed: If there are legitimate reasons for significant changes (such as a new business or major purchase), ensure you have documentation and be prepared to explain if audited.
11. Avoid Cash-Intensive Business Red Flags
Businesses that handle a lot of cash, such as restaurants, salons, or laundry rooms, are more likely to be audited. These industries are viewed as more prone to unreported income. If you’re in a cash-heavy business:
• Track income carefully: Keep detailed records of daily sales and ensure all cash is accounted for.
• Deposit cash frequently: Regular bank deposits help ensure that cash income is fully reported.
12. Use a Tax Professional. I would DO THIS FIRST and then review all the steps.
If your tax situation is complex, such as owning multiple businesses or having significant investments, hiring a tax professional or an accountant can greatly reduce the chance of mistakes. An expert will:
• Help optimize deductions and credits: Without crossing lines that would draw scrutiny.
• Ensure compliance: A knowledgeable tax professional can help you stay within IRS guidelines while maximizing your return.
While the IRS audit selection process can sometimes be random, adhering to the principles of accuracy, honesty, and consistency in tax filings can significantly reduce your chances of being audited. If your return does raise questions, being well-prepared with proper documentation and professional advice is your best defense. By understanding what the IRS looks for and following these practical steps, you can avoid common pitfalls that might otherwise lead to an audit.
