The Ins and Outs of an IRS Audit

What Happens If You're Audited?

Business woman looking at tax information
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You’ve received notice that the Internal Revenue Service wants to audit your tax return. If you’re like the vast majority of taxpayers, you’d rather jump off the nearest roof than face the steely stare and questions of an IRS agent. The prospect strikes abject fear in your soul, but take a deep breath and relax. 

It may not be as bad as you think. In fact, the majority of audits of individual tax returns involve nothing more than an exchange of correspondence. Here’s a summary of what you can probably expect and some words of caution just in case the situation turns out to be a little more complicated. 

Why You?

First, understand that the IRS is probably only slightly happier about this than you are. The whole process of auditing a taxpayer eats up its resources, and it may or may not result in additional revenue. In fact, only about 1 percent of personal returns are audited annually.

That said, certain triggers will force the IRS to look more closely at some tax returns. Most commonly, its computer runs up a red flag. Every tax return received is scanned by the computer to check for anomalies between it and other returns filed by taxpayers who are in a financial situation similar to your own. This is called the discriminate information function or DIF.

For example, most people who earn $75,000 a year do not give $50,000 of their income to charity, so if you did this and you claimed an itemized tax deduction for that amount, the IRS computer will sound an alert. Actually, what it does is assign each every return a DIF score. A high DIF score indicates that the information in your tax return is pretty odd. It doesn’t meet the norms for your financial situation.

Now a human agent steps in to personally review your tax return and decide whether it ought to be audited. The same would happen if two or more taxpayers claimed the same dependent. The computer scans for things like dependents’ Social Security numbers, too.

Another trigger involves returns that report information from the same financial transactions. For example, you might be an independent contractor who did some consulting for Big C Corporation. Big C’s issued you a 1099-MISC for your services. The corporation’s return was iffy in a couple of respects and Big C is being audited. An agent might review your personal return as well to make sure it’s precise because you did business with Big C, particularly if Big C paid you a great deal of money. If there’s anything hinky about your return, you can probably count on being audited.

Receiving Notification of an Audit

Here’s some good news: Most people who are being audited don’t even realize that it’s happening.

It all begins with receiving notice from the IRS after the IRS agent examines your return and determines that he has a few questions. The notice will arrive via good old U.S.P.S. mail. The IRS will not call you. It will not email you or send you a text message. If you’re alerted to an audit by any means other than a mailed notice on an official IRS letterhead, contact the IRS or law enforcement immediately because it’s a scam.

The notice will explain what the agent feels is amiss with your return. It may ask you to confirm certain information and it will probably ask for additional supporting documentation. Most important, it will tell you if you can simply return the documentation by mail, or if you must meet in person with an IRS agent.

Correspondence Audits

When you’re asked to return supporting documentation by mail, the IRS calls this a “correspondence audit.” Ideally, you’ll receive another notice a few weeks later, after you’ve supplied whatever the IRS is looking for, saying something to the effect of, “OK, thanks, this proves the information in your return is correct so we’re done now.” Or the notice might indicate, “Sorry, no, the information in your return is wrong and you actually owe us $500 more than what you calculated.”

Either way, it’s done. You’ve been audited, even if you didn’t realize it at the time. Just make sure you send the IRS that $500 or contact them to explore payment options. You’ll want to take some precautions when you mail in that documentation in as well. Be sure to forward it by certified mail, return receipt requested, so there’s no issue as to whether the IRS actually received it. You can also usually fax the requested documents so you’ll have a facsimile receipt showing that the transmission went through.

If the IRS misplaces the information after this point, it’s on them. 

In-Person Audits

The alternative is a full-fledged office or field audit. As the names suggest, an office audit takes place at an IRS location, whereas a field audit occurs at a place of your choosing, typically your home or your tax professional’s office. Either way, you’ll meet face-to-face with an IRS agent and be required to answer some questions. You may be asked to provide supporting documentation as well.  

The agent will review the troublesome areas of your tax return with you. 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. You’re meeting with the agent face-to-face because he wants to dig for information.

Some of the questions may seem innocuous, but the agent is really only interested in getting to the bottom of your return, and you can rest assured that they've done this a few times before and are experienced at fishing information out of taxpayers.

The agent may ask, “How was the drive? Did you encounter a lot of traffic getting here?” Don’t tell him how great your new Maserati is at skirting around traffic at high speeds. Just say, “No.” One word, a simple answer. Volunteer nothing extra, no matter how innocent the question seems. The agent will attempt to interpret every word you utter, so keep your answers short, sweet and to the point.

It’s also OK to decline to answer a question. You can always say, “Let me look that information up and I’ll get back to you with it by such-and-such a date.”

Many tax attorneys recommend that you do not attend the audit personally, either alone or with your tax advisor. Send your representative in your place. This, too, is perfectly OK. Just keep in mind that your representative must be “authorized”—in other words, he must have credentials recognized by the IRS. You can’t just take your brother-in-law because he minored in tax issues back in college.

About That Documentation 

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 get around to questioning returns and up to six years in some cases. This longer timeframe typically occurs because something about a more recent return has raised questions about an older one. 

You should therefore keep all supporting tax documentation—everything on which you based your tax return—for six years, just in case. 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 as well for backup. 

The Resolution

An audit resolves in one of three ways:

  • The IRS determines there’s not a problem with your tax return after all.
  • The IRS determines that there is a problem, and you recognize your error and agree with the agent’s findings.
  • You disagree with the agent’s findings.

If you agree, you’ll 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 with the IRS to further try to work things out, or you can speak to an IRS manager and perhaps convince him that the original agent’s estimation of the situation is wrong. You also have the right to appeal any IRS decision. You’ll most likely need the help of an experienced tax professional or tax attorney for this. There may be a statute of limitations, but a tax professional should be well aware of this, so see a professional right away if you want to dispute the audit’s findings.