I Am Being Audited by the IRS – What Do I Need to Know?
On the stress scale (10 being the worst), being audited by the IRS could be a 10. Audits can be bad and can result in a significant tax bill. But remember – you should not panic. There are different kinds of audits, some minor and some extensive, and they all follow a set of defined rules and procedures. If you know what to expect and follow a few best practices, your audit may turn out to be “not so bad.”
Kinds of Audit
There are three types of IRS audits: Correspondence-Mail, Office and Field audits.
1. Correspondence-Mail Audits-
Correspondence-Mail audits are fairly routine. IRS sends you correspondence and requires you to mail in documents responding to specific questions or requests for information. Correspondence-Mail audits make up 77% of all audits.
2. Office and Field Audits
Office or Field audits, on the other hand, are much more serious. The IRS will not only ask for information to validate your deductions and credits, but it will also look closely at your lifestyle, business activities and income, to see whether your tax return is accurate. Most tax evasion cases start from field audits. But don’t worry – the IRS prosecutes few taxpayers for tax evasion (about 2,000 every year). The IRS saves criminal prosecution for the most egregious tax evaders.
3. CP2000 Notice (Under-Reporter Inquiry)
There is also another way the IRS questions tax returns, but it’s not technically an audit. It is the Under-Reporter Inquiry, or CP 2000, and it’s very common. The IRS sends almost 4 million of every year. The CP2000 is a discrepancy notice that proposes a specific increase in taxes on your return. The IRS automatically sends these notices when there is a mismatch between income or deductions you reported on your return and information third parties have provided, such as Form W-2, Form 1099, and Form 1098s. A common example is when taxpayers do not report Form 1099-NEC/MISC income from work they did as an independent contractor during the year.
How Common is Being Audited?
Here are some numbers that show how common – or uncommon – the different types of audits can be:
- About 150 million total federal tax returns are filed each year.
- The IRS audits less than 1% of filers.
- Almost 90% of audits result in a change to the tax return.
- For mail audits, the average amount owed is more than $7,000.
- For office and field audits, the average amount owed is $65,000.
- The IRS sends Under-reporter Notices to about 2.5% of filers.
- About 66% of Under-reporter Notices result in additional taxes owed.
- For Under-reporter Notices, the average amount owed is about $1,500.
As unpleasant as an IRS audit can be, it will not go away. It is important to respond. If you do not, you will get a tax bill for additional taxes, and perhaps even penalties.
How to address an IRS audit
1. Understand the scope of the tax audit.
- Mail audits are limited to a few items on the audit letter you received from the IRS.
- Office and Field audits require more work. You will need to gather the information/documents that the IRS is requesting and prepare to answer in-depth questions about your finances and activities.
- When it comes to Office and Field audits, unless you are adept at IRS procedures, it’s highly recommended that you get a licensed tax professional (enrolled agent, CPA, or attorney) to represent you and advocate your tax return positions before the IRS.
2. Prepare your responses to IRS questions.
- For a correspondence/mail audits, prepare a complete response to the items the IRS is questioning in the letter/document you received.
- For Office and Field audits, prepare for the meeting with the IRS Revenue Agent. Gather all information the IRS has requested and prepare to present it to the IRS. Prepare for possible questions from the IRS, such as those concerning unexplained bank deposits or additional income. The IRS Revenue Agent will also ask about your job, family, and any outside businesses. Basically, you will need to be prepared to give an account of your entire year’s activities.
- If you do not have documents to prove any items on your return, you may have to reconstruct it from third parties or other records. If a third party can attest to an undocumented item, you can use techniques such as an affidavit.
3. Respond to IRS requests for information/documents on time and advocate your tax return positions.
- If the IRS thinks there is an adjustment to your return, the IRS will start asking more questions. You will get an Information Document Request, which you’ll need to fully respond to by the deadline.
- The IRS may disagree with you, stating, for instance, that you took a deduction that was not allowed or that you should have reported more income on your return. If you disagree, present your interpretation of the facts and tax law to the IRS Revenue Agent.
- Ultimately, the IRS will close the tax audit, either proposing no changes or proposing adjustments to your return. You will get a report of the IRS findings and a letter that allows you 30 days to appeal if you disagree (called the 30-day letter).
4. If you disagree with the results, appeal to the appropriate venue.
- Within 30 days, you can request an appeal with the IRS Office of Appeals. After 30 days, the IRS will send you a letter, called a Statutory Notice of Deficiency. This letter closes the tax audit and allows you to petition the U.S. Tax Court.
- In Correspondence-Mail audits, remember that the letter proposing adjustments also serves as a 30-day letter. Taxpayers commonly overlook this letter and lose their ability to appeal the audit findings with the IRS.
Take action!
Here are a few things you should do to get the best results in an audit:
Consider hiring a tax professional immediately, especially if you are not fluent in “tax.” Unless you can “Speak Tax” and can clearly articulate your tax return position to the IRS, you shouldn’t try to handle it yourself and hope for the best. Tax professionals trained in IRS Audits will provide the response needed to clearly communicate your tax position. If there’s an adjustment, a tax professional can help address proposed penalties. Learn about Legacy Tax & Resolution’s Audit Representation Services.
Make your responses complete and on time. Most audits and all under-reporter inquiries require corresponding by mail with IRS processing centers. There is no specific person assigned to your case, so the person viewing your response will rely on the quality and completeness of your response to interpret your tax position. If you want the best results, reply well before the deadline with an organized and thorough response that explains the items in question. Missed deadlines and incomplete responses lead to more notices and a higher likelihood that the IRS will close your audit and assess your additional taxes.
For office and field audits, prepare as if the IRS were auditing multiple years and your lifestyle. As the statistics show, office and field audits can result in a very high tax bill. That’s because the IRS looks to see whether there is any unreported income on the return. For example, the IRS can go through your bank statements and question deposits. Unexplained deposits can be considered taxable income if you can’t prove the nontaxable source, such as a gift or nontaxable sale of assets. Be prepared with an answer to these inevitable questions. A tax professional will be extremely valuable to help you prepare for office and field audits. Many taxpayers seek expert representation for these types of audits.
Assert your appeal rights when needed. Know that the auditor’s decision is not final. The first appeal is made to the auditor’s manager. The second appeal is made to the IRS Office of Appeals. During the appeals process, it’s important to respond by all deadlines or you will lose important appeal rights.
So, if you are being audited…. how bad is it? Potentially, a 10. But getting help from a tax professional, making timely responses and having thorough documentation mean that you can get through an audit with the best possible outcome.