An IRS tax audit is a review of your financial information to verify your taxes were filed correctly. The Internal Revenue Service (IRS) selects certain individuals for an audit for two reasons: random selection based on a statistical formula or if there is an issue with a taxpayer's tax return.
In this article, learn more about tax audits and how they work.
Definition and Example of an IRS Tax Audit
An IRS tax audit is a review of your financial records and tax payments to ensure you've paid the correct amount of taxes. Only around 0.6% of personal returns are audited annually, and the majority of these involve nothing more than an exchange of correspondence. However, in more extreme cases, you may have to meet with the IRS in-person.
Let's say you own your own business and made a large deposit of $10,001 at some point in the past year. Any time an individual makes a deposit over the amount of $10,000, the IRS may be notified. If this is the case and you file a tax return, you should be prepared to show how and why you received that money.
The Bank Secrecy Act is what requires businesses to report currency transactions that are more than $10,000. This is in an effort to help federal law enforcement and other agencies thwart illegal activities.
How IRS Tax Audits Work
A computer system scans every tax return the IRS receives to check for anomalies between it and other returns filed by taxpayers who are in a similar financial situation. This is called the discriminate information function (DIF). For example, most people who earn $75,000 a year do not give $50,000 of their income to charity. If you did this and claimed an itemized tax deduction for that amount, the IRS computer would likely trigger an alert.
The system assigns each return a DIF score, and a high one indicates that the information in your tax return is unusual and does not meet the norms for your financial situation. At that point, a human agent steps in to personally review your tax return and decide whether it should be audited. For example, this would happen if two or more taxpayers claimed the same dependent because the computer scans for things like dependents’ Social Security numbers.
Other triggers include returns that report information from the same financial transactions. Let's say you are an independent contractor who did some consulting for ABC Corporation, and they issued you a 1099-MISC for your services. If the corporation’s return is questionable and the organization is being audited, an agent might also review your personal return because you did business with them—especially if the firm paid you a substantial amount of money.
Most people who are being audited don’t even realize it’s happening. If an IRS agent examines your return and determines that there are questions to be answered, you will receive a notice through the mail that explains what they feel is wrong with your return.
The IRS may ask you to confirm certain information and provide additional supporting documentation, but more importantly, they will tell you if you can return the documentation by mail or if you must meet in person with an IRS agent.
If you are unsure of the answer to a question, you can decline to answer any question an IRS agent poses to you and say you will get back to them once you have looked the information up.
Most audits take place within two years of the filing date of a tax return, but the IRS technically has up to three years to conduct its questioning. If they find substantial errors, they may decide to go back up to six years, but this typically only occurs when something about a more recent return has raised questions about an older one.
You should keep all supporting tax documentation for six years just in case, but tax law requires that you keep it for at least three years. The IRS accepts electronically stored data in some cases, but you might want to keep paper copies for backup.
An audit is resolved in one of three ways:
- The IRS determines there is no problem with your tax return.
- The IRS determines there is a problem and you recognize your error and agree with the changes.
- The IRS determines there is a problem and has proposed changes that you disagree with.
If you agree, you will be asked to sign an examination report and possibly remit a few more dollars in taxes. When you sign and pay, that’s it; your audit is over. If you disagree, you can ask for mediation to try and work things out, or you can speak to an IRS manager and perhaps convince them that the original agent’s estimation of the situation is wrong. You also have the right to appeal any IRS decision.
Types of IRS Audits
An IRS audit can occur in many forms, depending on the circumstance.
When you are asked to return supporting documentation by mail, the IRS calls this a correspondence audit. Ideally, you will receive another notice a few weeks after you have supplied the required documentation that confirms that your return is found to be accurate and the audit is over. If it turns out that you owe the IRS money, you will receive a notice that your return was wrong, and you must send the IRS the requested amount or contact them to explore payment options.
Take some precautions when you mail in documentation to the IRS. Use certified mail with a return receipt requested, so there is no doubt that the IRS actually received it. If the IRS misplaces the information after this point, it is their responsibility.
You can also fax the requested documents so you will have a receipt showing that the transmission went through.
In more severe cases, you could face a full-fledged office or field audit. An office audit takes place at an IRS location, whereas a field audit occurs at a place of your choosing—typically your home or tax professional’s office. You will be required to meet face-to-face with an IRS agent, answer some questions, and provide supporting documentation. A correspondence audit typically focuses on one narrow issue, while an in-person audit usually indicates that the IRS has more than a few questions about your return.
A face-to-face meeting with an agent is because they want to dig for information. Some of the questions may seem innocuous, but the agent is only interested in getting to the bottom of your return. Many tax attorneys recommend that you not attend the audit personally—either alone or with your tax advisor—but instead send an authorized representative. Authorized representatives must have credentials recognized by the IRS.
- An IRS tax audit is a review of your financial records and tax payments to ensure you've paid the correct amount of taxes.
- Only about 0.6% of personal returns are audited annually, and most of these are correspondence audits, which means you can send required documentation via mail or fax.
- The IRS determines who is audited by scanning tax returns and looking for anomalies.
- Most audits take place within two years of when the return was filed, but you should keep your supporting tax documentation for six years in case the IRS needs to go back further.