On a list of real-life nightmares, most people would rank “tax audits” right up there with having a tooth pulled. The primary trauma of a tax audit is that it makes many people feel like they’re on trial and are being accused of a crime. Don’t panic. You may be audited for many reasons, and not necessarily because the IRS thinks you’re a crook. You may receive that audit notice because some of the information on your return doesn’t match up with information from third parties, because an IRS data entry operator added (or subtracted) a zero off a number on your return, or because your return deviates from average returns in your neighborhood or your income range. Finally, some returns are plucked at random, and searching for a reason will just make you crazy! This post provides light knowledge about tax audits.
About 15 percent of audited returns are left unchanged by the audit — that is, the taxpayers don’t end up owing more money. In fact, if you’re the lucky sort, you may be one of the rare individuals who actually get a refund because the audit finds a mistake in your favor! Unfortunately, it’s more likely that you’ll be one of the roughly 85 percent of audit survivors who end up owing more tax money, plus interest. How much hinges on how your audit goes.
What You Should Know About Tax Audit
Most people would agree that not knowing what to expect in a situation is what’s most terrifying about it. This is even truer when dealing with the IRS. Here’s what you need to know about tax audits:
- You needn’t attend your audit. An EA, CPA, or attorney can go in your place.
- If at any time during the audit you feel hopelessly confused or realize that you’re in over your head, you can ask that the audit or interview be suspended until you can speak to a tax pro. When you make this request, the IRS must stop asking questions and adjourn the meeting so you can seek help and advice.
- The burden of proof is on you. You’re considered to be guilty until proven innocent. Unfortunately, that’s how our tax system operates. However, if you and the IRS end up in court, the burden of proof switches to the IRS, provided you meet the IRS’s substantiation and recordkeeping requirements and present credible evidence. What all this means is that you can’t just sit in court and say “Prove it” to the IRS.
- Unless a routine examination reveals the likelihood of unreported income, the IRS can’t conduct a financial status audit by demanding that you fill out Form 4822, Statement of Annual Estimated Personal and Family Expenses, so the IRS can determine how you lived on the income reported on your return.
- Although it’s true that the number of people being audited is not great, more people are being audited now than in the past several years. The IRS’s computers constantly compare the information received from employers, banks, and brokers with the information reported on people’s returns. Because of these constant comparisons, millions of taxpayers each year are sent bills totaling billions of dollars.
- Through a major shift of its audit priorities, the IRS is now targeting high-income earners, self-employed taxpayers, small businesses, and workers who receive tip income because it believes that these groups possess the greatest ability to not report all their income. Low-income taxpayers haven’t escaped the wrath of the IRS, though. The IRS continues to crack down on perceived Earned Income Tax Credit (EIC) abuse, so returns with Schedule EIC often receive extra scrutiny.
The Four Types of Tax Audits
Thankfully, only four types of audits exist: office audits, field audits, correspondence audits, and random statistical audits, more commonly referred to as the audits from hell. With all four types of audits, maintaining good records is the key to survival. Let’s take a look at the four types of tax audits in more detail. Read on…
. Office Audits
An office audit takes place at an IRS office. The IRS informs a taxpayer that it’s scheduling an office audit by sending Notice 904. The front of this notice lists the date, time, and place of the audit, and the back lists the items that the IRS wants to examine.
The audit date isn’t chiseled in granite. If you can’t gather the information necessary to substantiate the items the IRS is questioning, you can request a postponement. As a general rule, the IRS grants only two postponements unless you can demonstrate a compelling reason for an additional delay, such as an illness or the unavailability of certain tax records.
If you need more time but can’t get an additional postponement, go to the audit with the records you have, put on your most confident face, and calmly inform the tax examiner that you need more time to secure the documents you need so that you can substantiate the remaining items the IRS is questioning. The tax examiner then prepares a list of the additional items the IRS needs to complete the audit, together with a mailing envelope so you can mail copies of the requested documents to the IRS.
Never, ever, mail originals. If the additional documents don’t lend themselves to easy explanation through correspondence, then schedule a second appointment to complete the audit.
Most office audits are concerned with employee business expenses, itemized deductions such as medical expenses, charitable contributions, tax and interest expense deductions, miscellaneous itemized deductions, deductions for personal exemptions, and moving expense deductions. Lately, the IRS has expanded office audits to include small-business returns, income from rental property, and income from tips and capital gains.
If the IRS is trying to verify your income, it may want to know about your lifestyle. How will the IRS find out about your lifestyle? You’ll tell them, that’s how. Auditors are trained to control the interview. They feign ignorance, use appropriate small talk, use “silence” and “humor” appropriately, and avoid overtly taking notes so as not to distract the taxpayer, and they pay attention to the taxpayer’s nonverbal language. The IRS even has a form to flush out lifestyle information, Form 4822, Statement of Annual Estimated Personal and Family Expenses, which — thank heaven — the IRS can now only spring on you when a routine examination has established the likelihood of unreported income.
The form asks all about your expenses, from groceries to insurance — anything you and your family would spend money for as consumers. We don’t know what it is about this form, but when the IRS shoves it under someone’s nose, many taxpayers can’t resist the urge to respond, “I’ll show them what it costs to live in this country.” What most people are unaware of is that you’re under no obligation to fill out this form. The law only requires you to fill out and file a tax return. Statistical research has revealed that the IRS can collect more tax by examining sources of income than by examining deductions. If you operate a small business or have rental income, be prepared to explain where every deposit into your bank account came from.
. Field Audits
Field audits are conducted at a taxpayer’s place of business. These audits focus on business returns and complex individual returns. If you file Form 1040, Schedule C, you’re a likely candidate for a field audit.
Again, be prepared to verify the source of every deposit into your bank account. Field agents are required to survey both your preceding and subsequent years’ tax returns to determine whether similar items were treated in a consistent manner. If an audit results in a significant increase in tax, you are now suspect, and the tax examiner will audit your subsequent years’ tax returns (which normally are only surveyed).
An office audit specifies what items will be examined from the very beginning of the process. Not so with a field audit — tax examiners have a great deal of discretion as to what items they review and to what depth they review the items. Count on having to verify your total income, travel and entertainment expenses, gifts, automobile expenses, commissions, payments to independent contractors, and any expenses that appear large in relation to the size of your business.
A tax examiner may examine each and every deduction or merely select a month or two of expenses and examine them on a sample basis. If they don’t turn up any discrepancies, the examiner will accept the rest of the expenses for that category as correct.
Where Audit Maybe Happened?
Both field and office audits are conducted in the district where a return was filed. This practice may create a burden if you live in one district and are employed or have your business located in another.
Example: if you work or your business is located in Manhattan and you live in Connecticut, you normally would be contacted by the examination branch in Connecticut. If your tax records are in Manhattan or you spend most of your time there, you can request that the examination be transferred to the Manhattan District. Besides gaining the convenience of having the audit conducted where your records, your advisor, or your business is located, you also get a little more time to pull together your tax data.
To transfer an audit from one district to another, call the IRS auditor and tell him or her why you want to transfer the audit to a different district. The transfer usually takes two to three months. The IRS also requires that you request the transfer in writing.
The following note will suffice when requesting that a tax examination be transferred from one IRS district to another:
[address of district that issued exam notice]
Re: [your name and your Social Security number] [exam year]
Dear District Director:
Because my tax records are located in [for example, Manhattan] and I spend most of my time there, I respectfully request that the audit you have scheduled be transferred to the [for example, Manhattan] District.
You may contact me during business hours at [telephone number]. Thank you in advance for your prompt attention to this request.
Very truly yours,
Correspondence audits are exactly what the name suggests. The IRS conducts correspondence audits completely by mail and limits them to a few key areas of individual returns, such as itemized deductions, casualty or theft losses, employee business expenses, IRA and Keogh plan payments, dependency exemptions, childcare and earned income credits, deductions for forfeited interest on early withdrawals from savings accounts, and exclusion from income of disability payments. Income items may also be examined by a correspondence audit.
If you’re ever the proud subject of a correspondence audit, the IRS gives you a return envelope in which to submit your documents, canceled checks, bills, and statements to substantiate the items the IRS questions. Again, never send original documents — only copies.
Retaining the originals is crucial in case you have to stare down further inquiries, or if the IRS does the unthinkable and loses your documentation. When it comes to substantiating any deduction, the burden of proof is on you. If what you must substantiate is complex or requires a detailed explanation, you can ask for an interview in which you can explain in person.
Random Statistical Audits
Although it’s extremely unlikely, your return may be selected at random for an audit, just because the IRS can. These random statistical audits are used to gather information to determine pockets of tax cheating and errors. The IRS, however, never uses those words. It refers to failing to report income or inflating deductions as “non-compliance”. Under its research program, the IRS annually selects certain types of taxpayers’ returns (waiters, taxi drivers, freelance writers, and so on) so it can measure the degree of tax compliance for particular industries, trades, or professions. On the basis of these audits, the IRS National Office determines which areas require stricter or greater enforcement efforts. Although being on the receiving end of one of these audit notices is never fun, in this environment of large federal budget deficits, the IRS is unlikely to suspend this current project.
If you are selected for a random statistical audit, the IRS may review your return in the following ways: computer checking, correspondence, and face-to-face. Everything is subject to verification, but in most cases, only certain lines will be checked. Be prepared, though, to provide your children’s birth certificates to prove you’re entitled to claim your kids as dependents. If something smells fishy or doesn’t look right, you can count on being questioned in detail about the matter. The IRS looks under every rock, including matching up cash settlements you may have received in a personal injury lawsuit, for example.
Questioning Repetitive Audits
It’s IRS policy not to examine an individual’s tax return if the taxpayer has been examined for the same issue(s) in either of the two preceding years and the audit resulted in no (or only a small) tax change.
If you receive a notice of an audit questioning the same item(s) questioned in a previous audit, call the agent and inform him or her that the IRS audited the same issue(s) in one of the two prior years with little or no change in tax. (And do note that the IRS has never bothered to define little. Changes of less than a few hundred dollars in tax, however, should meet this criterion.) The tax examiner will ask you to furnish proof. Mail the examiner a copy of the IRS notice that your prior return was accepted without change, or mail the notice that adjusted your return.
If you can’t document that the IRS is questioning items that it already questioned — with no change in tax — in one of the two preceding years, the lack of documentation doesn’t mean that you can’t get the current examination canceled. Just inform the examining agent by telephone about the prior year’s tax examination. The tax examiner will postpone the audit and request a Record of your Tax Account Information from the two preceding years.
If your tax account supports your contention, the IRS will cancel the audit.
Getting Ready for a Tax Audit
Preparing for an audit is sort of like preparing for a test in school: The IRS informs you of which sections of your tax return the agency wants to examine so that you know what to “study”. The first decision you face when you get an audit notice is whether to handle it yourself or to turn to a tax advisor to represent you. Hiring representation costs money but saves you time, stress, and possibly money.
If you normally prepare your own return and are comfortable with your understanding of the areas being audited, represent yourself. If the IRS is merely asking you to substantiate deductions, you’ll probably do all right on your own.
What constitutes substantiation may at times involve a somewhat complicated interpretation of the law and its accompanying regulations. If the amount of tax money in question is small compared to the fee you’d pay a tax advisor to represent you, self-representation is probably the answer. However, if you’re likely to turn into a babbling, intimidated fool and are unsure of how to present your situation, hire a tax advisor to represent you.
Changing your mind regarding representation partway through the audit is okay. At any time during the examination — such as when you feel a dizzy sensation and before you throw up in the examiner’s lap — the Taxpayer Bill of Rights allows you to request that the audit be suspended until you have time to consult with an enrolled agent, a certified public accountant, or an attorney. After you make this request, the IRS agent must stop asking questions or requesting documents until you’re properly represented.
But if you do decide to handle the audit yourself, get your act together sooner rather than later. Don’t wait until the night before to start gathering receipts and other documentation.
You may discover, for example, that you can’t find certain documents. You need to document and be ready to speak with the auditor about the areas the audit notice said were being investigated. Organize the various documents and receipts in folders. You want to make it as easy as possible for the auditor to review your materials. Don’t show up, dump shopping bags full of receipts and paperwork on the auditor’s desk, and say, “Here it is — you figure it out.”
Don’t bring documentation for parts of your return that aren’t being audited, either. Besides creating more work for yourself, you’re required to discuss only those areas mentioned in the audit letter.
Whatever you do, don’t ignore your audit request letter. The Internal Revenue Service is the ultimate bill-collection agency. And if you end up owing more money (the unhappy result of most audits), the sooner you pay, the less interest and penalties you’ll owe.
Who Can Represent You In A Tax Audit?
The IRS permits three types of individuals to fully represent taxpayers before the IRS: enrolled agents, certified public accountants, and attorneys. All three are bound by IRS rules of practice. (Tax preparers can still represent you at an audit but not in any appeals beyond that, but recent bills in Congress seem to support limiting un-enrolled preparers from providing this service much longer).
Enrolled agents (EAs) become enrolled to practice before the IRS by passing a two-day written examination administered by the IRS in which their knowledge of the tax code is tested. Alternatively, they must have at least five years of experience as an IRS tax auditor.
Attorneys and certified public accountants are the other two groups permitted to represent taxpayers before the IRS. Many states have continuing education requirements for CPAs and attorneys. The IRS requires that EAs also meet continuing education requirements. Probably the best way to find a qualified tax professional is to ask a relative or friend for a recommendation of someone whose level of service and performance they are more than satisfied with.
Appealing The Results Of A Tax Audit
The IRS issues Form 4549-A, Income Tax Examination Changes, and Form 1902-B, Report of Individual Tax Examination Changes, after an audit has been completed. Form 4549-A spells out any adjustments to income and expenses that have been made and any penalties and interest that are due.
These notices often are referred to as 30-day letters. Within 30 days after receipt of an audit notice, you must agree to the adjustment, submit additional information explaining why an adjustment shouldn’t be made, or request a hearing before the Appeals Division. If you disagree with the proposed adjustment, and the amount of tax is more than $25,000, a written protest must be filed. IRS Publication 5 (Your Appeal Rights and How To Prepare a Protest If You Don’t Agree) is extremely helpful in preparing a protest. Consider retaining a tax advisor when protesting large sums. This written protest is akin to a legal brief lawyers submit in outlining a case.
Appeals, you guessed it, are made to the Appeals Office, whose purpose is to settle disputes. The IRS agent who examined your return has no authority to take into account the time and expense to the IRS and the possibility that the IRS may lose in court. An appeals officer can. Approximately 90 percent of all cases referred to the Appeals Office are settled.
If the amount involved isn’t more than $25,000, a formal written protest isn’t required. A simple statement explaining the changes you don’t agree with and why you feel your deduction should be allowed is all that is necessary.
The IRS also issues a 30-day letter if you fail to show up for an audit. In such an instance, the examining agent will review your return and make adjustments to both income and deductions that he or she deems warranted.
If you receive a 30-day letter because you failed to show — even if you missed the audit because you never received the original notice scheduling it — contact the agent at the number given on the letter and schedule an audit appointment. If you make a new appointment within 30 days, the examining agent or appointment clerk will place a hold on your adjusted return (that is, it won’t be processed), pending the outcome of the rescheduled audit.
After completing the audit, the IRS issues a new notice of income tax changes that supersedes the preceding one. If you agree to the audit changes and sign off on them, you can pay what you owe at that time, or you can wait to be billed.
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