Internal Revenue Service (IRS) Audits

What is an Internal Revenue Service (IRS) Audit?

The IRS can challenge the accuracy of a tax return through an audit or, what the IRS refers to as an “examination.”   Audits involve an IRS auditor’s (tax examiner, tax compliance officer, or revenue agent) review of the books and records (i.e., receipts, invoices, etc.) of the taxpayer to determine the accuracy of your tax return.

The Audit Process

The goal of an IRS audit is to determine whether the taxpayer reported a “substantially correct tax liability”:  In most cases, the IRS does not review the entire return.  Most audits review whether the taxpayer reported all of their income, from all sources, on their tax return and any other “sizeable, rare, or questionable” item(s) found on the tax return.

Audits have to follow a process that protects taxpayer rights:   The process is referred to as “deficiency procedures.”  These procedures allow the taxpayer a right to appeal the findings of an audit before the tax is assessed and paid. In the audit, the taxpayer is given time to provide documentation to support items reported (and not reported) on the tax return.  At the end of an audit, the IRS may or may not propose adjustments/changes to the return. The taxpayer will have the right to appeal the adjustments in the IRS Independent Office of Appeals and Tax Court prior to the tax being assessed.

There are many ways you can be selected for audit:  the most common selection method is a refund hold scenario.  If the IRS suspects an obvious error on the return, it may freeze the taxpayer’s refund and audit the return.  Other common sources of audits are computer-selection (based on how much the return has the probability of error), an IRS compliance project (the IRS decides to concentrate audit resources on an issue or type of taxpayer, like a small business), or the taxpayer is selected because they have related transactions to another ongoing audit (like a partner in a partnership).

There are three types of audits:  the mail (correspondence), office (“desk”), and field audit.  The mail audit is the least intrusive.  Both the office and field audits are done face-to-face, with the auditor interviewing the taxpayer and/or their representative.  Office and field audits are more involved and usually involve more complicated taxpayers and issues.

Most audits are automated mail audits:  75% of all audits are mail audits in which the taxpayer needs to answer IRS questions and provide documents to support the accuracy of their filed tax return.  The most common mail audit issue is the earned income tax credit.   The mail audit process produces automated letters which can cause problems (tax assessments, lost appeal rights) for the taxpayer if they do not respond timely.

A field audit is rare- and should be taken seriously by the taxpayer:  a field audit occurs at the taxpayer’s home or place of business.  It is the most comprehensive of all IRS audits and is completed by an IRS revenue agent who has special training and skills to handle more complex situations.  In these audits, the IRS is also looking closely for unreported income and possible tax evasion.  Taxpayers should often engage a professional to work with the IRS in these complex audits.

IRS makes changes in 90% of all audits: the IRS knows which returns to audit.  9 out of 10 audits end up with a change to the return.

IRS audits trigger the most serious penalties, including criminal prosecutions:  The most common penalty is a 20% accuracy penalty.  However, most IRS tax evasion cases start out as IRS field audits.   Tax evaders can be criminally prosecuted but also face a 75% civil fraud penalty.

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