A tax audit is when the Internal Revenue Service, or IRS, selects your tax return for a review. This is intended to determine whether your income, deductions, and any payments or refunds are correct.
An audit is usually triggered when something on your return is out of the ordinary. This is often due to a computer program flagging abnormalities in your return. It could also happen because you report an abnormally high or abnormally low income, claim a deduction that is frequently misused, or belong to a group that often has errors in returns, such as home-based business owners.
Though having your tax return audited can be stressful, there are steps you can take to prepare, ensure that the process goes as smoothly as possible, and minimize the likelihood of severe financial penalties.
Types of IRS Tax Audits
When you first hear from the IRS, they will send you an official letter letting you know the type of audit that will be conducted.
- Do you get a letter from the IRS saying that you owe an additional small amount of tax? That is the most basic type of audit. It's often sent to people who are self-employed.
- Does the IRS want you to mail receipts and documents for them to review? That's what we call a correspondence audit.
- Does the IRS want to schedule an appointment for you to come into their office and bring your documents with you? This is an office audit.
- Will the IRS send an agent to visit you at your office? This is called a field audit.
If you are being audited, you will receive official, mailed correspondence from the Internal Revenue Service. If you receive an email or a phone message stating that you owe the IRS money and must pay immediately, that it most likely a scam.
"The most common audits now are correspondence audits. They're usually pretty cut and dried," says Frederick Daily, the author of Surviving an IRS Tax Audit and a tax attorney in private practice. In a correspondence audit, you mail copies of your receipts or other documentation to the IRS, along with any notes or explanations. An IRS agent reviews your documentation and lets you know by mail whether there will be an adjustment made to your tax return.
In some correspondence audits where the amounts are small, the IRS simply sends you a letter stating how much additional tax you own, usually a few hundred dollars or less.
For an office edit, you bring your documentation and receipts to a local IRS office, then sit down with the auditor and go over everything in person. You'll find out right away what the auditor is thinking and what adjustments he's proposing.
A field audit is where an IRS agent comes to visit you at your place of business or at your accountant's office. A field audit is considered the most serious type of audit, and the target is almost always a business owner or self-employed person.
Preparing for an IRS Audit
No matter what type of audit you are undergoing, there are a few basic steps you will need to take to prepare.
- Read the letter from the IRS. This will tell you what type of audit they will be conducting, how serious it is, and how you will communicate with the IRS agent.
- Review the Information Document Request. This will tell you what the auditor is focusing on and what documents you must provide.
- Print hard copies of your tax returns. In addition to the return for the year in question, it is also a good idea to have tax returns for the four years surrounding the year in question, in case you have to prove a history of creditable tax paying or show that you have similar expenses every year.
- Gather your documents. Along with your tax returns, you will need receipts for expenses and deductions, 1099 or W2 forms, and profit and loss statements for your business. You may also need to provide bank statements to prove that your income was accurately reported.
- Go through receipts and deductions on your own. Before you meet with the auditor, go through your profit and loss statements, tax returns, deductions, and receipts to make sure everything matches up.
If you discover any discrepancies or mistakes, present those to the auditor yourself right away. If you wait for them to be discovered, it can make you appear dishonest or lead the auditor to conclude that you have a history of improperly prepared tax returns.
Tips for Managing an IRS Audit
How your auditor perceives you can have a significant impact on the outcome of your audit. "I could take [an] audit in front of 10 different auditors and get 10 different results. It's an art as well as a science," says Daily. "IRS agents have a lot of discretion."
Whether you communicate with your auditor solely by mail or meet in person, you improve your chances of a positive outcome by being cooperative, professional, and honest.
- Create a positive first impression. Be prepared and organized before meeting with the auditor. Gather all the paperwork that was requested, plus anything else that might be helpful or explain your situation.
- Read the audit technique guide published for your situation. It will tell you what specific questions the auditor will ask.
- Be honest. If you discover any discrepancies or mistakes, present those to the auditor yourself right away. If you wait for them to be discovered, it can make you appear dishonest or lead the auditor to conclude that you have a history of improperly prepared tax returns.
- Make the auditor's job easy. If you are asked for additional information or paperwork, such as a spreadsheet to help match up the amounts in different bank accounts, provide it promptly.
- Establish deadlines early. The IRS encourages agents to complete audits within 90 days. If your situation seems straightforward, establishing a deadline will encourage your auditor to close your case and move on.
- Ask questions. Speak up if you confused or need clarification. Be sure you understand any penalties your auditor is imposing.
What to Do During an IRS Audit Without Receipts
If you are a business owner or a self-employed person, the auditor will likely want to look at deductions and business expenses that you claimed. Depending on how far back the auditor wants to look, you may no longer have receipts for some of these expenses.
If your receipts are lost, you can still prove that you paid certain amounts. Provide copies of your bank statements with the correct amounts going in and out, along with information about the vendors who received those payments.
This will be more successful if you can show that you are business savvy and believable early on in the audit process.
- Show a history of paying taxes properly, this establishes that you are a credible taxpayer.
- Provide any paperwork that the auditor asks for and an explanation for anything that is missing. Show that you are honest and not trying to hide anything.
- Help the auditor become familiar with your business so that they understand how you spend and make money.
If you can establish credibility as a business owner and a taxpayer early in the process, your auditor is more likely to accept portions of your tax return that you do not have receipts for.
Finding a Tax Professional to Represent You in an Audit
Being audited is intimidating, especially if your business is on the line. You may prefer to handle an audit on your own, or you may feel more comfortable having someone else talk to the IRS for you.
If you decide to hire someone to help you with a tax audit, look for:
- An enrolled agent
- A certified public accountant
- A tax attorney
Professionals with these credentials are permitted to represent you before the IRS in a tax audit. Some professionals also complete further training to become fellows in the National Tax Practice Institute. This is an educational program that trains them on how to handle audits and other types of tax problems.
You might find that you don't feel comfortable dealing with the IRS, or you might need help organizing your documentation. A properly credentialed tax professional can help you prepare for your audit and meet the auditor with or without you.
Even if you feel confident about your upcoming audit, you may want to at least consult with a tax professional for an hour or two. A professional can give you a sense of where you might run into trouble with the IRS or notice problems in your paperwork that you overlook.
When you use a tax preparation software, you may have the opportunity to pay an extra fee for audit protection and support. This ensures that if you are audited, the company will provide a tax attorney or audit specialist to consult with you.
If you are missing any paperwork or didn't keep records of expenses, you should definitely bring in a tax professional to assist with your audit and meet with your auditor. Tax professionals are trained in how to handle this type of situation and can advise you on what your options are.