The IRS audit process varies depending on the type of audit being performed. As you will see, the IRS conducts several types of audits and has different ways of selecting taxpayers for those audits, the majority of which we will discuss below. If you are currently under audit with the IRS or are otherwise concerned about the IRS audit process this article will help clear things up.
What Can Trigger An Audit?
Typically there are four major audit triggers which can lead to an IRS audit. On top of this, different triggers will cause a different type of audit. It is important for you as the taxpayer to understand what the IRS is looking for. This will help you stay reduce the chance of an IRS audit and stay in tax compliance.
- Failing to File a Tax Return for Multiple Years (missing returns)
- Leaving Certain Items of Income Off your Return
- Large, Unusual, and Questionable Items on your Return (LUQs)
- National Research Program Audits
Failure to File
The tax forms you receive at the beginning of each year (W-2, 1099-MISC, 1098, etc.) are not just being sent to you so you can prepare your return. The IRS also receives a copy of these forms and stores this information in a database. By doing this, the IRS can then determine who has a filing requirement.
Failing to file a tax return when you have specific sources of income can trigger the audit type under IRC § 6020(b). In this type of audit the IRS will actually prepare a return for you using the information stored in their database for the tax year in question. These returns are referred to as a Substitute for Returns (SFRs). However, these returns are not being filed on your behalf because the IRS wants to help you out. When the IRS prepares these returns they will only include the information they have reported, which means they will not account for any deductions, special tax treatments, filing status, dependents, etc. Ultimately, these returns almost always result in a larger tax liability being due.
The IRS could also decide to simply conduct a full blown audit, especially when you operate a sole proprietorship or are otherwise self-employed. During the audit the IRS will request all of your records (bank statements, receipts, etc.). If you are unable to produce the records they are requesting, even if you have partial records, or you just can’t figure out how to prepare them for the audit interview, the likelihood of you being assessed a large tax bill increases. The best course of action is to file the returns on time to avoid the risk of audit all together, even if you know you will owe but cannot pay.
Missing Items on Your Return
The second type of audit is an Automated Underreporter Audit (AUR). How you are selected for an AUR is very similar to an audit that is triggered by having missing tax returns. Remember the information the IRS compiles from your W2, 1099-Misc, 1098, etc.? Well, the IRS will cross check the return you file with the information they have in their database. If the information does not match the IRS will send a notice requesting an explanation. Responding to the notice that is send is very important. If you do not respond, the IRS will assess a deficiency and apply a 20% accuracy related penalty.
Common Items Left Off Taxpayer Returns:
- 1099-Misc (generally from self-employment income).
- If income is shown in box 7 for non-employee compensation the IRS will treat this income as self-employment income. Self-employment income is subject to Federal Income Tax and 15.3% employment taxes.
- If the income is from self-employment, the IRS will not automatically give you credit for expenses (mileage, insurance, rent, etc.).
- 1099-B (From the sale of stocks).
- The IRS typically does not receive information about your basis in the stock. This means the IRS will tax you on the entire gross proceeds instead of the gain. You can also lose preferential capital gain tax treatment because the IRS may not be able to determine whether it is a long-term or short-term capital gain.
- 1099-R (IRA or 401k distribution).
- If left to the IRS does not know if you had a qualifying reason for taking money from your retirement account. Because of this, you could be assessed an additional 10% penalty for early withdrawal.
- You may not get credit for basis in the retirement account.
A third common audit trigger is related to what is reported on your tax return. The IRS will often task Revenue Agents to hand review large batches of tax returns. The Revenue Agents are looking for Large, Unusual, and Questionable items.
- LUQ Breakdown
- Large: Comparatively large expense on a schedule C (i.e. realtor shows $50,000 of gross income and $40,000 in Schedule C expenses, $30,000 of those expenses are repairs). Also, any single large deduction or expense that exceeds or nearly eliminates the taxpayer’s income from other sources.
- Unusual: The IRS will look at the character of the expense (airplane expenses for a plumber, etc.).
- Questionable: Using round numbers on each expense line of a Schedule C. This tends to suggest you are making the number up.
This doesn’t mean that you won’t ever have LUQs on your tax return. If you do, make sure to keep adequate records to defend against the higher chance of an audit.
The IRS Audit Process
The process of an audit depends on the type of audit and the location of the audit. The audit process can be divided into three categories.
- Correspondence Audit
- The IRS requests substantiating documents through the mail.
- You usually do not get to speak with an auditor, which often times results in having additional taxes assessed.
- The goal is to send in credible documents that address/prove every element of the specific Internal Revenue Code (IRC) section.
- In-Office Appointment
- You are required to schedule an appointment at your local IRS office with a Tax Compliance Officer (TCO) or Revenue Agent (RA).
- The auditor (TCO or RA) will ask a series of questions to determine if additional years or items on your return should be opened.
- Responding to the notice is important because the auditor could decide to open other years and items if you don’t. The auditor will also disallow all the deductions (because you did not respond) and assess a substantial tax deficiency.
- Field Audit
- The audits are less common due to the IRS budget being what it is.
- They are typically limited to businesses.
- The auditor will schedule a time to come out to your business location and review finances. This can cause an interruption in business operations.
Each of the IRS audit processes follows the same general path. You first received a notice for the audit with a request for information. The information request tells you what areas and years have initially been selected for review. However, these are not set in stone.
Your 2017 and 2018 Schedule C is selected for audit. You go to the audit and during the interview the auditor determines you there may also be items on your Schedule A you are not eligible for. The auditor then decides open up your Schedule A for the audit and schedules a follow-up appointment.
This situation can be avoided. Having a tax attorney represent you for the audit is often times a great solution. The auditor will typically not ask as many questions and/or the attorney can limit the scope of the audit. In addition, you can continue with work or otherwise keep your regular schedule rather than having to meet with the auditor.
Once the initial interview is completed, the auditor will issue a Form 4549 Income Tax Examinations Changes, which contains the recommended changes from the audit. The 4549 will also be accompanied by an 886-A, which will explain why an expense was allowed or disallowed. If you believe the recommended changes are incorrect or you disagree you can call the auditor and try to argue your case. If that does not work, see below (What to do if you missed the audit or disagree with the outcome).
How to Handle the Results of an Audit if you Disagree
If you missed the initial audit deadline or disagree with the recommended changes, you still have options. There are several administrative and procedural steps that are available after an audit has completed. Here are the three most common options available.
- Appeal your case
- Petition the United States Tax Court
- Submit an Audit Reconsideration Packet
You will receive a 30-day letter with appeal rights after the audit is complete. This gives you 30 days to submit an appeal for consideration by the IRS Office of Appeals. During the appeal, you will can present any contested areas for independent review by an IRS Appeals Officer. If you missed the original audit, you may need to file an appeal to preserve your rights (you should seek legal advice on this matter).
You will receive a Statutory Notice of Deficiency if you do not appeal within the 30 days or you lose your case at appeals. This document is legally significant because it gives you 90 days (150 days if you are out of the country) to petition the United States Tax Court. If you miss the deadline, you will lose your right to seek review from the Tax Court. However, there is another option available.
You can still submit an audit reconsideration packet if you miss the deadline to petition the Tax Court. This is strictly administration and at the discretion of the IRS. In other words, you do not have a statutory right to audit reconsideration. However, by presenting new information not already considered, the IRS should accept the packet for review. This can be a powerful tool, especially if you missed the initial audit or tracked down additional substantiating documents.
Statute of Limitations on Audits
Given certain circumstances, the IRS can audit you for every year you file a tax return and assess additional tax. This is usually only the case where there is fraud on the part of the taxpayer. In most cases, the IRS can only assess additional taxes for 3 years. There are other factors that can extend the statute of limitations on assessments.
- The IRS is generally limited to three years to assess additional taxes.
- This limit is extended to six years if you omit 25% or more from gross income (see more at IRC § 6501(e)).
- The limit becomes indefinite if you file a fraudulent return or fail to file a return at all.
Whether or not the IRS can audit/assess additional taxes beyond the three year mark is a fact specific inquiry. You should seek immediate counsel from a tax attorney if you feel the IRS has exceeded its authority.
Information That Could Save Money Before or After the Audit Process
When dealing with the IRS or other taxing authority leverage and preparation are vital. You need to arm yourself with as many tools as possible. Two overlooked strategies that can help your negotiating power with the IRS is submitting a “qualified amended return.” The other is proposing a “qualified offer” to the IRS.
Qualified Amended Returns
A qualified amended return is submitted before you are notified of an audit for a particular year.
You are notified that your 2018 tax return has been selected for audit.
You realize a mistake made on your 2016 and 2017 returns and believe the IRS will audit these years after the interview for 2018.
If you file an amended return for 2016 and 2017 and correct the mistake BEFORE a notice is received, this could save you significant penalties. At a minimum, you should be able to avoid the 20% accuracy related penalty.
Whether or not you should file a qualified amended return is fact specific. You should speak with an experienced tax attorney to develop a strategy that is right for you.
A qualified offer usually occurs after you petition the United States Tax Court (but before the trial). You offer an amount to the IRS that you believe will be proven during court, which will put pressure on the IRS. If the final decision at court results in a liability for less than the amount you offered the IRS will lose out on the additional amount you offered and you can get the IRS to pay for your representation. The IRS must take these offers seriously because they do not want to lose the case and foot the bill for your attorney.
The IRS audit process can be stressful. However, if you feel overwhelmed, stressed, or underprepared it is a good idea to seek out legal representation. It is never too late to hire an experienced tax attorney. In fact, if you find yourself at the local IRS office at your initial audit appointment and are uncomfortable answering questions or providing the information your have you can tell the auditor you would like to hire an attorney and reschedule. It is your right! If you would like to find out how we can help resolve your IRS audit please give us a call for a free phone consultation.