Note - This article is not intended to provide legal or tax advice of any kind. It is purely intended to help educate visitors on the various types of audits. If you have specific questions about an audit you have received, please speak with your CPA or a tax attorney.
An audit, as it pertains to taxes, is an official examination of a taxpayers filings. There are two common types of audits the Internal Revenue Service performs; paper and in person with each handled differently.
The first of the two, the paper audit (also called an IRS notice letter), occurs much more frequently than in-person audits. About 1% of all returns are audited, the majority of which are done via paper. In the event that a mistake/error was made on a filing, a notice is sent to the taxpayer making them aware of the issue along with the result of the mistake (usually a balance due). Most often, these are notices saying that they have checked, found errors, recalculated the tax bill and this is what they believe the difference to be.
The taxpayer is usually asked to agree to one of the following: accept the changes in entirety, accept part of them or if they disagree with the changes provide additional documentation supporting this. Most often, the errors are just a case of human error. Either the taxpayer forgot to report some of their income (stock sale, interest, contract work, etc), or (if they choose to calculate the return themselves) it contained inaccurate math.
In-person audits are usually reserved for more complex or egregious discrepancies. The process begins with a notice being sent asking the filer to call and set up an appointment with the agency. The agent will provide details on the issue in question and ask that you meet to discuss it. Often, the documents required will be specified in the original notice, but may be clarified if necessary over the phone.
Appointments are typically set with enough time to ensure the person can prepare all necessary documentation. If a CPA was used on the original filing, notification of this request is usually sent to them as well. Most times the filer will include their CPA and sometimes a tax attorney in the proceedings.
With either type of audit, a taxpayer should not delay response. If they plan on challenging the changes it is worth noting that, in most cases, a "non response" indicates acceptance of the changes. If more time is necessary it is certainly acceptable to request that.
How to Avoid Triggering an IRS Audit
The IRS processes millions of tax returns every year. In fact, they processed an estimated 280.6 million withholding documents for tax year 2014. Because of this huge amount of information, the IRS only has the time and resources to take a closer look at a very small percentage of tax returns. This "closer look" is referred to as an audit.
An audit verifies that your income and deductions are accurate. There are certain aspects of a tax return that trigger an audit. The IRS assumes that many of these triggers are signs of potential fraud or mistake. Below are a few of the items that may trigger an audit.
- Significant changes in income. If you made a lot less or a lot more money last year, the IRS may want to take a closer look at your return. Significant changes from year to year sometimes signify that a taxpayer is underreporting their earnings. If you have large itemized deductions, this may also be a red flag for the IRS.
- Unreported income. The IRS receives all of your W-2, 1099s, etc. If you leave information off, then the IRS may assume that you are not reporting all of your income in other areas as well. Be sure to include information from each and every income form that you have.
- Excessive business expense deductions. Business owners want to take full advantage of the deductions available to them, but some of these deductions toe the line of being unethical. The IRS has information and charts that show the average business deductions for a business that earns a certain level of income. If your business expenses are above that average, then your return may get flagged. Unfortunately, the IRS does not tell you what this average is.
- Self-Employed Individuals. If you have self-employment income, this may also be a red flag for the IRS. This is not an automatic trigger, however. If you have a home office and significant business expenses, but not much income, then the IRS will be more interested. They want to be sure that your business is legitimate and not just a way to decrease taxable income from other sources. If you own rental properties and claim a loss of income, then the IRS may look at your tax return a little closer as well.
Be sure to report all of your income and keep your business expenses reasonable, and you will better your chances of avoiding an audit. Accuracy is important, so report income and expenses exactly as they are in your documentation. You should also keep documentation that shows expenses and income in the event of an audit.
How to Appeal a Tax Dispute
If the IRS has audited your return and made a tax determination and you don’t agree with their assessment, you can appeal it. Appealing may be worth the time and effort when large sums of money are involved or where future tax obligations are affected.
If you plan to appeal, most taxpayers find the best first step is to visit the Office of Appeals. The Office of Appeals is an independent organization, created in 1927, to deal with tax controversies in an effort to decrease tax litigation costs for both individuals and the government.
These professionals help individuals and businesses resolve tax disputes with the IRS without the time and expense associated with taking a case to Tax Court. The process of using the Office of Appeals is less formal than going to court, and it is typically more efficient as well. Although the service is offered through the IRS, the professionals in the Office of Appeals do not take sides in a tax dispute. Instead, they attempt to offer an unbiased third party.
The Office of Appeals deals with many federal tax issues, including collections and assessments. Whenever the IRS makes an assessment, the Office of Appeals can potentially be utilized.
The Appeal Process
In the final decision letter, the IRS will explain your rights to appeal their decision. If you do not agree with the decision, you should not sign any agreement form that has been sent to you.
You should explain why you disagree with the decision when appealing it. It is not enough that you are dissatisfied with the decision.
There are two types of appeal requests. If the money involved is less than $25,000, then the appeal is for a small case. If it is over $25,000, then you will need to go through a formal written protest. In a small case, you should send a letter to request an appeal. Within that letter, state the changes that you do not agree with and why you do not agree. Use Form 12203 to provide this information.
In a formal written protest, you must include additional details and information beyond the reasons that you do not agree with the decision. You should state facts and provide evidence. If appropriate, cite the law or authority upon which you are relying. You will also need to sign the form under the penalty of perjury.