Getting Audited by the IRS
If you’re visiting this page, perhaps it’s because you’re being audited by IRS; or maybe you’re wondering what the IRS audit triggers are; or perhaps you’re just interested in learning about the IRS audit process. Regardless of why you’re here, it’s important to understand how to protect your rights during an audit.
Types of IRS Audits
Most individuals will likely deal with an IRS audit at some point in their lives. It may be a simple correspondence audit, or it may be a field visit to your business.
Correspondence Audit Program
A correspondence audit is conducted through (you guessed it), correspondence. Such audits are for issues that involve records that can easily be submitted by mail. Examples of issues that are covered by a correspondence audit include:
• Dependent Exemptions
• Earned income tax credits (EITC)
• Child Care Credits
• Adoption Credits
• Educational Credits
• Certain itemized deductions and Schedule C expenses
While correspondence audits are less intimidating since they do not involve a face-to-face audit, they can be extremely frustrating. First, there is no one assigned to your case. These cases are worked by Tax Examiners, which is an entry-level position requiring no college education. The case will be handled by a different person each time you call the IRS or submit documents. Because it’s an entry-level position, Tax Examiners are given very little ability to make judgments in gray areas of the law. You may have to go back and forth over the course of several months to get an issue resolved at the correspondence audit level. If you’ve been unable to resolve your issues in a correspondence audit, hiring a tax professional may help.
Automated Underreporter Program (AUR)
The IRS uses computer-matching and error-checking programs to verify the accuracy of tax returns. The most common notice generated by the AUR is a Notice CP2000. A CP2000 informs the taxpayer that there is a discrepancy between income shown on the tax return and income that was reported by others. For example, if you had cancellation of debt (which is considered income), the creditor will issue a 1099-C to you and file it with the IRS. If your tax return does not include that income, the AUR will generate a Notice CP2000 informing you of the mismatch.
An office audit is a face-to-face examination with a Tax Compliance Officer (TCO). The majority of cases worked by a TCO involve Schedule C issues. The TCO will audit up to 4 vital issues and possibly additional issues on the return with managerial approval. If you are chosen for an office audit, you will receive an examination letter, requesting you to call and set up a day and time to have your return and supporting documents examined. The TCO will also send you an Information Document Request (IDR) which contains a list of documents that the TCO wants to review.
TCOs are trained to not only verify questionable expenses and credits on the tax return, but to also look for unreported income. Such examinations can be highly invasive and difficult for clients. However, you should know that TCOs are not allowed to automatically request bank statements without meeting specific criteria in the Internal Revenue Manual.
If you’ve received a letter requesting an office examination, you need to hire a tax professional. There’s too much at stake to attempt this yourself. One thing that taxpayers and even tax professionals don’t know is that the TCO will have completed a background search on you prior to the appointment. They also have the authority to make 3rd party contacts to verify documents that you provide. A false statement or document from you could result in the audit turning into a fraud case. I’ve seen it happen, and in fact, I’ve personally had to turn an audit case to fraud on a few occasions while working at the IRS.
Field audits are conducted through on-site visits by a Revenue Agent (RA). Unlike TCOs who examine individual, self-employed, and disregarded entity returns, RAs examine only business returns. In addition, there are RAs in the Small Business/Self-Employed (SB/SE) department and RAs that are assigned to Large Business and International (LB&I). SB/SE revenue agents will audit business returns with assets under $10 million.
The first contact with an RA is through a letter providing a time, date, and place of examination of the taxpayer’s books and records, along with an Information Document Request (IDR). If you have a representative, the examination can be conducted at the practitioner’s office.
A field audits will always include a reconciliation of income from books, records, and bank statements to the tax return. The revenue agent will already have picked some issues to review prior to the examination but will examine additional issues as warranted.
IRS Audit Triggers (“Red Flags”)
If your tax return doesn’t match information returns (e.g., 1099s, 1098s, W-2s etc) filed by 3rd parties, that’s obviously an automatic trigger for an adjustment letter from the IRS.
All tax returns are scored through a computer program called Discriminant Inventory Function (DIF). Certain tax filers, such as those with Schedule C or EITC, seem to have higher DIF scores and therefore a higher chance of getting audited. Additionally, any tax returns that appear to have “large, unusual, or questionable” (LUQ) deductions or expenses may cause the return to be flagged for an audit. For example, if you’re claiming $30,000 charitable contributions but earning only $70,000 of income, this is LUQ based on your income level. However, for an individual earning $500,000, a $30,000 contribution might not be considered LUQ.
For Schedule C and business filers there are various factors that can cause the DIF score to increase. For instance, your business expenses will be compared with similar businesses nationally and locally as identified through the business’ NAICS code. If your business expenses appear out of line compared to other similar businesses, that may increase your DIF score.
How to Prepare for an Audit
If there’s ever a reason to hire an attorney, an IRS audit should be at the very top. Unless your records are in perfect order and you have records to substantiate every deduction taken on the return, do not attempt to handle this on your own. The benefits of having a tax attorney on your side, especially one with prior IRS experience, will more than offset the costs of representation.
After you’ve hired a tax attorney, you and the attorney should have an honest discussion about your tax returns and identify any weak links, such as expenses that you may have accidentally overstated or are unable to provide documents. Your attorney can help limit the damage.
How Far Back can the IRS Audit you?
The Internal Revenue Code (IRC) contains time periods within which the IRS must assess and collect tax. These limitations are known as “statute of limitations.” Section 6501(a) of the IRC states that an assessment of any income tax must be made “within 3 years after the return is filed.” This applies even if a return is filed late.
However, there are exceptions to the 3 year statute of limitations:
- False, fraudulent, and unfiled tax returns. There is no statute of limitations where a taxpayer files a false return, engages in a willful attempt to evade tax, or does not file a tax return.
- A return is filed with a substantial omission of income. The IRS may assess taxes within 6 years of a tax return filing where the taxpayer omitted more than 25% of the reported income for the year under examination.
Example 1: Bob files his 2014 tax return on 4/15/2015. The IRS has until 4/15/2018 to audit and assess any additional taxes on the return, absent fraud or more than a 25% omission of income.
Example 2: Bob files his 2011 tax return on 4/15/2012. Bob’s 2014 tax return is audited by the IRS and after reviewing his bank statements, the IRS discovers that he underreported his income by more than 25% in 2014. The IRS now has until 4/15/2018 to audit his 2011 tax return.
26 U.S. Code § 6501 – Limitations on assessment and collection