Approximately 1 million taxpayers get audited each year, which is less than 1% of all taxpayers. Though the odds of being audited are slim, you still probably cringe when the words “tax audit” are uttered. It is a hassle, but this guide should help alleviate some of the stress you may be feeling by answering questions you may have about audits.
What is an IRS Tax Audit?
The IRS defines a Tax Audit as a review and examination of an organization’s or individual’s accounts and financial information to ensure information is reported correctly according to the tax laws and to verify the reported amount of tax is correct.
Who Gets Audited by the IRS?
“According to the IRS statistics, people in higher tax brackets and people who report no income at all get the most attention (Paden, 2019).”
As you can tell with this graph, between 2016 and 2017, the number of audits decreased dramatically for those with lower to medium-sized adjusted gross income amounts.
In 2016, the focus was more on those who made between $1 and $50,000. In 2017, that changed a lot. The focus shifted to millionaires. This should give you a good idea of who got an audit.
Remember: The IRS usually audits people on the tax returns from the previous years; so, just because this graph is years old doesn’t make it obsolete information. The IRS is still auditing and working with tax returns from 2016 and 2017, so remember to keep your tax returns from prior years and supporting documentation, as you never know what could be amiss on those older tax returns.
An audit does not always mean you did something wrong. Often those who receive an audit are randomly chosen or are selected via a computer program that finds discrepancies. There are also related examinations where the IRS compares information on your tax return to that of those who are related to you somehow, such as employees, investors, or business partners.
For more information on how to prevent the IRS from targeting your business, check out this article.
What are the Chances of Being Audited?
According to CNBC, only 1 out of every 220 taxpayers were audited in 2019 for the 2018 tax year. Whereas 10 years ago, it was 1 out of every 90 taxpayers. Each year the odds get lower.
The IRS only did audits on .45% of individual tax returns in 2019 (Iacurci, 2020). The decline in audits is due to budget and personnel cuts at the IRS, but it’s great news for taxpayers! It means fewer audits!
There is an Audit Odds Calculator you can use to see what chance you have of getting audited (based on the facts of your 2018 tax return). Are you thinking, “That’s out of date; how does it apply to me now?
Well, most audits ARE based on old information. The IRS is still catching up on mistakes from the 2017 – 2018 tax years. So, this year’s tax return may not even be on their agenda yet.
Unfortunately for some, certain individuals have a higher chance of being audited just because of their income. “Wealthy Americans are much more likely to be audited than low- and middle-income taxpayers (Iacurci, 2020).”
The IRS does not target-rich taxpayers because they have more money; they target the wealthy because of their questionable investments in things like planes, vacation homes, cars, and yachts. There is just more room for errors on these types of tax returns.
If you do happen to be unlucky enough to get audited, you can take solace in knowing that about 75% of all audits are done via the mail. This is the fastest and easiest way to handle an audit. All you need to do is read what is asked of you and provide them with what they need.
While, in general, you have a slim chance of getting audited, some things can increase your odds of getting audited; these are called audit triggers which are things you want to avoid or at least prepare for if they are unavoidable.
What Are Some Examples of Audit Triggers?
By preventing or preparing for audit triggers, you can greatly reduce your chances of getting audited. Here are the top 10 audit triggers and what you can do to be prepared if one of them applies to you:
- Unreported or Missing Income – Don’t hide any income. The IRS can match up 1099’s and will know if you forgot to report something. Keep a notebook or ledger throughout the year that lists all your income, who paid you, how much, and so on.
- Claiming Business Losses Year after Year – The IRS’s viewpoint: Why are you still in business if you are losing money? Be prepared to explain why you are keeping a losing business alive. Don’t forget to keep excellent business records.
- Underreporting Income from a Cash Business – It’s easy to miss a $50 haircut you did and got paid cash, and the IRS knows this. They have ways of checking this out, so keep a ledger of your income as listed in #1.
- Rounding Numbers and Making Mathematical Mistakes – Since the IRS has last year’s tax return and your business records, they will know if you are taking a short cut here; sloppy work makes them question other areas of your taxes. Use numbers to the penny or hire a tax specialist to do your taxes this year.
- Reporting Excessive Business Expenses – Many people overestimate how many business expenses they have so the IRS does watch out for overstatements here. Keep all receipts, invoices, packing slips, etc. Maintain a spreadsheet with all your business expenses for the next tax year.
- Mixing Business and Personal Expenses – When the line between business and personal is blurred by the taxpayer, the IRS will take a closer look to make sure those expenses are justified. Is your car really for 100% business use? Keep an accurate mileage log to show all the details. Do this for all your business expenses that may be blurred with personal expenses. Be honest with your home office deductions.
- You are Self-Employed – This is an area that many taxpayers take advantage of. Keep in mind the IRS can match records on its end to see if you are being forthright about your business income. Follow the advice listed on #1 and keep an up-to-date ledger with all the business income you earn listed along with all the other details you may need if you get audited.
- Having a lot of Charitable Contributions – Don’t overstate your contributions or you may catch the attention of the IRS. There’s nothing wrong with donating to charity; just keep the receipts from the places you donate to.
- Doing Business Out of the Country – The Foreign Account Tax Compliance Act has strict reporting requirements for a foreign bank account. Make sure your account balances are what you are claiming them to be and fill out your tax forms correctly to avoid any problems.
- Losses on Hobbies – Losses are limited to the income from the hobby, so don’t overestimate how much you spent on your hobby. Keep income records of what you do make from the hobby, and of course, keep all receipts showing your expenses for your hobby.
If you have one or more of these audit triggers, that doesn’t mean you will get audited. Some audits are random! If you have audit triggers, you just may have a greater chance of getting audited.
For more details on some of these, this article on audit triggers will explain in-depth what to do if you fall under the audit trigger of one or more of these:
- Missing Income
- Claiming Business Losses Year after Year
- Underreporting Income from a Cash Business
- Rounding Numbers and/or Making Mistakes
- Reporting Excessive Business Expenses
- Mixing Business and Personal Expenses
The key is to file completely, accurately, and honestly. Have the proper documentation and even if you do get audited, you should have nothing to fear.
When in doubt, hire a tax consultant to go over your taxes with you to make sure that you are recording everything the way you should. Also, a tax professional can help represent your interests in the case of an audit.
What are the Different Kinds of Audits?
There are 3 main types of IRS audits. Usually, the kind of audit you are presented with is dependent upon how serious the audit is.
- Correspondence Audit – This type of audit is done via mail. It’s the simplest and most popular (75% of audits are done this way) type of audit. The IRS will ask you to turn in something specific; make copies and send it in. It’s usually as simple as that.
As the video below will explain, there are typically two types of correspondence audit notices you may receive: A 566 letter which will ask for something specific to be mailed in OR A CP2000 notice which basically says your records do not match with theirs; in the case of a CP2000 notification, they will just suggest an adjustment to your tax return.
- Office Audit – This type of audit is done at one of the IRS’s local offices. It is more common that a field audit, but typically too complex, more detailed, or has more issues than a correspondence audit. Take the approximate 2 weeks they give you to go over your records and make copies of what you think they need. Each meeting may take several hours so be prepared.
An IRS office audit usually is regarding items listed on Schedule A, C, or E. There will be lots of questions relating to the issue at hand. For this audit, it’s best to have a tax specialist with you who can help prepare you and speak on your behalf in order to figure out what the IRS needs.
- Field Audit – This type of audit is done at your home, place of business, or your tax professional’s or accountant’s office. This is the most comprehensive, detailed, serious, and intrusive audit the IRS does. They will review in person your tax and financial records, so have them all copied and ready for the IRS agent.
Beyond your records, they will probably want to interview you and ask you plenty of questions. Now is an excellent time to have a tax accountant and/or tax attorney present to represent you or to speak on your behalf. The importance of a tax professional is that they can ensure your rights are not violated in the audit.
This simple IRS video explains a little more about IRS notifications and what you can expect them to say. It also has valuable advice on what to do once you receive your first IRS notification letter.
For more information on correspondence audits, watch this less than 5-minute YouTube video by the IRS that will quickly walk you through the normal audit process for a correspondence audit.
For more information on how a CP2000 notification works, what its for, and how to handle this type of correspondence audit, watch this very short YouTube video from the IRS that will explain everything.
Understanding Audits: What Are They Looking for?
The IRS will provide you with a written request for the specific things they want to see. They are typically looking for proof of something you are claiming on your tax return. They may also want to review your past bank statements to see if there was any income that was not reported on the appropriate tax return. Here is a listing of the records the IRS may request.
If you need additional time to prepare the documentation and records that they need for the audit, you can send them a written request asking for an extension. You are allowed a one-time 30-day extension to gather the information you need.
How Can I Prepare for an Audit?
Check out this IRS Audit Preparation Checklist for a detailed explanation of each of these points.
- Hire a credentialed tax professional to represent you – A tax specialist will understand tax laws and be able to represent you during an audit. Find an excellent tax accountant who will look out for your best interests.
- Understand the reason why the IRS is auditing you. It will be difficult to get the documentation and paperwork ready for the IRS Agent if you do not know what they need you to have handy. Read the first correspondence carefully to see what they need.
- Understand HOW the IRS will be auditing you. – Determine the seriousness of the situation by reviewing the notification. Will it be in person, via the mail, or at your local IRS field office? Most audits are completed via the mail because it’s a faster and easier way for the IRS to audit you.
- Understand what the IRS needs from you – Read your first correspondence from the IRS carefully so that you can get ready whatever the IRS is asking for.
- Understand what happens during an IRS tax audit – Knowing what is involved in an IRS tax audit can help alleviate any stress and/or anxiety you may be having.
- Understand your rights as a taxpayer – Read the IRS’s Publication explaining the Taxpayers’ Bill of Rights before your tax audit so you understand the process better and what you can and cannot do about it.
- Understand your payment options – The IRS offers many payment options if you cannot pay your back taxes, penalties, and interest when it is due. They have a payment plan that helps you make installment payments over time rather than all at once. Read more about the other options they have available.
- Gather and organize any documentation you may need – One of the keys to having a successful audit is having the right documents. Here are a few examples of what you may want to have ready for the IRS agent:
- Copy of the first and any subsequent IRS audit notification letters
- All documentation requested in the audit notification letters
- Bills, receipts, logs, and anything else you keep track of
- Proper mileage logs
- Copies of all the tax returns in question (bring all tax returns if possible)
There is another additional way you can prepare yourself for an audit: Audit Yourself. Check out the instructions in this article on how to “Audit Yourself.” There’s a great IRS audit technique guide there as well as some sound advice. The purpose of doing a self-audit is to prepare yourself and your records for what they may ask of or need from you.
What is the Audit Procedure? Follow this 6-Step Process.
Each audit is different; the amount of time it takes to complete an audit depends on the circumstances. This is the 6 step IRS audit procedure that holds true for most IRS tax audits.
Receive the Audit Notification. The audit begins when you receive your first audit notification from the IRS in the mail. The IRS WILL NOT contact you over the phone.
Understand the Purpose of the Audit. The first notification will usually explain why you are being audited, what type of audit you will be having (office, correspondence, or field), and what they will need from you to complete the audit. Read it carefully and follow it to the letter.
Begin the Audit Proceedings. Depending on the seriousness of the audit, you will begin the actual audit process either by mail or in person. If the IRS has a simple request for you, the entire process can be done by mail. If the IRS has serious concerns, they may need to meet you either in your home, office, or at their closest field office.
Have Proper Representation. You may have an attorney and/or an accountant present during the audit proceeding. If you would like a tax specialist to go in your place, you will need a proper Power of Attorney form, see IRS Form 2848. This article discusses how and why you may want to have someone go in your place in the “Do you need help?” section.
Know Your Rights. The Taxpayer’s Bill of Rights state that you may stop an audit at any point in time if you decide you want proper representation to be there with you or to be there in your place.
Understand the Flow of the Audit. Again, depending on the request they have for you, it could take anywhere from one meeting to interviews that continue for weeks or even months. Typically, the correspondence is by mail and is only one simple request that you must reply to with the requested documents.
Top Tips for Resolving an Audit
- Be prepared. Have everything that the agent will ask for in your hands – organized and ready to go. Making copies of the documents you think they will need isn’t a bad idea either.
- Be professional, show respect, and try to stay calm. Realize that the agent isn’t after you personally so don’t show up in a hostile mood, but also do not treat them too informal. This is a business meeting.
- Watch what you say. Try not to go on tangents as to why you did something specific on your taxes. Aim for concise responses to the agent’s questions. For example, if you say that you “always do your taxes that way,” you may be inviting further analyses of your past tax returns.
- Don’t take the easy way out. If you agree with them on a mistake you made, then agree upon a solution, but if you do not agree, don’t just go along with the solution the agent suggests just to end the audit.
Understand that their job is to find quick solutions. Look for a compromise if possible, but don’t just settle. In these cases, it’s best to have a tax professional with you to do the talking on your behalf.
What Happens After an IRS Tax Audit?
Audits end in one of three ways:
- No change in your taxes, what you owe, or what you reported
- Changes, taxes owed, or other reasons that you agree with
- Adjustments that you do not agree with, causing you to begin the appeals process
Most audits end when the taxpayers who are being audited agree to pay all the taxes, penalties, and interest they owe. This could mean just setting up a long-term payment plan with the IRS or discussing other payment options if you cannot afford to make monthly payments.
If you agree with the findings, you will be asked to sign the examination report or similar form depending on the type of audit conducted. If you find that you owe the IRS a lot of money, there are several payment options available if you cannot pay right away. Publication 594: the IRS Collection Process explains the collection process in more detail.
You can ask for another meeting with the auditor if you have new evidence to present; also, you can make an informal appeal to the auditor’s boss explaining your side of things. If you’re still unsatisfied, you can go to the IRS regional appeal level. You also have the option of taking your case to court (McCormally, 2019). For more information on IRS Appeals, check out this YouTube video on appealing a tax dispute.
What Happens if You Disagree with the Auditor?
Don’t be rude or combative but do hold your ground if you disagree with the tax agent. The IRS offers mediation, or you can file an appeal if there is enough time remaining on the statute of limitations.
The latest statistics show that out of almost 900,000 audits, more than 18,000 taxpayers disagreed with the auditors’ findings and disputed close to $2 billion of suggested additional tax.
If you disagree with the final report, tell the auditor, and restate your position. He or she may be willing to compromise (McCormally, 2019).
Do not settle on a decision you disagree with. The auditor does not have the final say on what happens as a result of his or her audit report. If you disagree, you can request a conference with an IRS manager.
If you are still dissatisfied after speaking with the IRS manager, you can appeal the decision, request assistance from the Taxpayer Advocate Service, or go to court if necessary.
What is the IRS Appeals Process?
If you disagree with the IRS’s decision, you can file an appeal with the U.S. Claim Court, the U.S. Tax Court, or your local U.S. District Court.
You may be able to continue appealing all the way to the U.S. Court of Appeals or even the Supreme Court if they agree to take on your appeal case against the IRS regarding your taxes.
Protect Yourself in the Case of a Future Audit
The best way you can prepare for an audit in your future is to keep excellent records. Here are a few tips to get you on the right track:
- Use a filing cabinet or folders in a box. Keep track of your papers in an organized fashion so that you know where everything is.
- Save the last 7 years of tax returns along with all the back-up documentation that led you to enter the numbers on your tax returns.
- Save and organize invoices, checkbook registers, receipts, bills, and tax documents.
- Keep a journal of all tax-deductible information that you claim and where the back-up information is stored next to each entry.
- Store and organize all your tax information in someplace safe like a fire-proof safe.
Check out even more tips on how to practice good recordkeeping when it comes to your taxes and tax-related documentation in this CBS article.
If you are audited, you will probably have to hire a professional tax consultant and have all relevant documentation and receipts ready to go. This guide should help you with every aspect of an IRS audit; if you have any questions or need one-on-one assistance, contact Borshoff Consulting! We can meet your every tax and financial need including representation during an audit.