There’s one thing individuals and business owners dread: an IRS audit. If a notification letter that the government agency intends to audit your tax return arrives in your mailbox, relax. By knowing what to expect and how to prepare for the audit, there’s no reason to fear Uncle Sam or, in this case, the Department of the Treasury.
What Is an IRS Audit?
An IRS audit is a process where an auditor employed by the federal government reviews your financial information to verify that what you reported on your tax return is correct. An IRS agent also substantiates that the amount you paid to the Department of the Treasury is accurate.
Auditors normally look at your last three returns but they can go back as far as six years when there are substantial errors.
Types of IRS Audits
Not all audits are the same, some are less complex and therefore less stressful.
When the IRS notifies you that you will be audited, it will also inform you what type of audit you’ll go through:
- Correspondence audit. Many audits take place over correspondence, and they are the least extensive and least invasive as auditors mainly check whether you report all income or take erroneous deductions.
- Office audit. In some cases, instances, you could be required to meet an agent at an IRS office.
- Field audit. Other times, a tax compliance officer may conduct the exam at your residence or business office. This is the most comprehensive audit.
By filling your taxes correctly, you avoid the risk of having an IRS audit.
Does the IRS Choose Who to Audit?
The most common reason why the IRS might audit someone is that they found red flags in your tax return. Things like:
- Your return had unusual or strange deductions
- The IRS thinks you omitted certain items from your deduction
- Your deduction has a high potential for mistakes
Some more concrete examples are:
- not reporting W-2 wages
- not reporting interest earned
- not reporting income received when selling stock.
Since 1969, the IRS uses an algorithm called Discriminant Index Function (or DIF) that gives your tax return a numerical score. This number scores the likelihood of your tax return having mistakes.
Going to the right place to seek assistance when tax time comes is highly recommended. If you don’t want to file your taxes yourself, you can pay a fee and choose a retail tax preparer to assist you or a Certified Public Accountant.
Other ways the IRS may select you for an audit are:
- Random Selection: The IRS uses a statistical formula based on an internal National Research Program. They compare returns for what’s normal based on random tax return samples.
- Related Examinations: If the IRS audits business partners or investors you know, there’s a higher likelihood that you’ll be audited as well. When those same people had issues, the IRS may take a deeper look at your returns.
How Common are IRS Audits?
Just so you know, IRS audits are pretty rare. For individuals with lower incomes, the IRS audits less than 1% of individual tax returns per year. For individuals with gross incomes of more than $5,000,000, 4.21% of tax returns are audited.
Here are statistics compiled by TaxDebtHelp.com: in 2018, less than 1 million of more than 150 million individual tax returns were audited equating to 0.59%. The audit rate for S Corporations and Partnerships was 0.2%, for small corporations 0.6% and for large corporations 8.1%.
What To Expect and How To Get Ready?
Before the Audit
The IRS never initiates an audit by telephone. They send a formal letter that provides contact information and specific instructions about the upcoming event. Within the letter will be a response date and a written request of documents they want to see.
Examples of documents they need for businesses are receipts, bills, canceled checks, legal documents, loan agreements, medical and dental records, employment documents, or K-1s issued by S Corporations to shareholders. Additionally, the IRS may send a questionnaire with general questions about vehicles, travel, meals, entertainment, and repairs.
You can contact your auditor to find out if they will accept electronic records in lieu of physical documents. Group records by income, expenses, and deductions, so when the audit time comes it’s easier to verify what you submitted on your tax return.
During the Audit
Once your records are in order, you can retain the services of an accountant as your representative to handle all requests made by the auditor. Before the audit occurs, your accountant should review your tax return thoroughly so you can go over any issues beforehand.
Tax professionals work with IRS personnel frequently so this isn’t anything new for them. Plus, they know what questions to ask your assigned auditor and provide you with brief answers.
Auditors normally ask background questions first relating to your address, phone number, where you work, and your education level. They want to know who filled out the return, whether you have household employees, and if you’ve had tax returns examined previously.
Likewise, they may ask detailed questions about how you generate income: rent, inheritance, public assistance, self-employment, and other fund sources. They may also ask if you have a safe deposit box or foreign accounts.
Auditors ask these questions to find out if you’re not declaring income or claiming false business expenses.
After the Audit
The IRS concludes an audit in three ways: a) They don’t find any changes to make; b) They propose changes that you agree to; c) You disagree with their findings.
If you agree with their recommendations, you sign the examination form and pay what’s due. The IRS offers several payment options: you can use your debit or credit card or make electronic payments online.
You can also ask the IRS to delay collection until you are able to pay what’s due and even apply for an Offer in Compromise to reduce the amount owed if you can’t pay it in full. But you should never disregard a bill sent by the IRS. If you do, they will begin collection actions to seize property and assets. When you delay your payment, the IRS continues to charge penalties and interest.
If you dispute the audit results, you should request a meeting with an IRS manager. You can use the mediator services available through the IRS, appeal the decision, or hire a tax attorney to begin litigation proceedings to dispute and settle the claim.
Other Frequent Asked Questions
Is it bad to get audited?
It depends. Some audits are random, so if you think you filed your taxes correctly, you shouldn’t be worried. Other audits take place because the IRS flagged your return for being inaccurate. In that case, follow the steps above to get properly prepared.
Which type of IRS audit takes occurs at your home or business?
As you have read, most IRS audits are held over correspondence but, in more serious cases, you could face an IRS office or a field audit. An office audit takes place at an IRS location, whereas a field audit occurs at a place of your choice, which can be your home, workplace or your tax professional’s office.
What’s the worst that could happen?
The IRS would adjust your return to remove deductions you claimed and can’t substantiate, or they may include income you omitted. Then you would pay the tax due, penalties, and interest charged calculated from the time that tax should have been paid.
How long does an IRS audit process take?
The length of an IRS audit varies depending on the complexity of the return and how long it takes to provide information to auditors. Many times there are scheduling conflicts when the taxpayer doesn’t agree with the auditor’s findings.
What if I need more time to prepare?
The IRS grants a one-time, 30-day extension. You must request more time in writing via e-file or letter.
If I’m an undocumented immigrant, should I be concerned about my immigration status?
If you reported your taxes using an ITIN in lieu of a Social Security Number, the outcome of an IRS audit shouldn’t differ from that of an audit to someone with an SSN. Your ITIN allows you to legally report income and expenses and take qualified deductions without having a social security number.
However, if you used a false SSN or you simply evaded taxes, there could be serious complications involving your immigration status.
Now you Know How to Prevent an IRS Audit
There’s no guarantee you won’t be audited but you can put the odds in your favor. One of the best things you can do to offset an audit is to purchase tax software, which helps prevent calculation mistakes and alerts you of business deductions and tax savings you may not know about.
As long as you submit legitimate expenses, pay taxes, file your tax return on time, and don’t use business funds to pay for personal expenses or fail to declare multiple income sources, you’re in good shape. Additionally, keeping good records of your expenses should be a top priority. Even if you’re audited, you’ll sail through just fine.
Camino Financial can help you stay on top of other concerns like these you may have. We publish a weekly newsletter that includes tips and timely articles like this one to help you grow your business.