Ultimate Guide to IRS Tax Audits

Everything you need to know about IRS tax audits

IRS audits are one of the most stressful events you can go through as a taxpayer, even if you haven’t done anything wrong. According to a recent survey, 32 percent of Americans would prefer to break their arm, 13 percent would gladly spend a night in jail, and 6 percent would sell a kidney rather than doing their taxes. You have to wonder what they would do to avoid a tax audit! Although audits are never fun, they don’t have to be a traumatic experience.

If an IRS Notice of Audit and Examination is making your life miserable, relax. Instead of panicking, prepare yourself with our tax audit survival guide. By the time you finish, you will know what to expect, how to stand up to the IRS, and where to get help. You will even learn a few tricks on how to avoid issues in the future.

Why do I have an IRS Audit?

The chances of getting audited by the IRS are low. Less than 1% of taxpayers get a second look from the IRS (source). If you just received an examination notice (jargon for audit), you are probably asking yourself how this could happen to you. More than likely, a computer is to blame.

When selected for an audit, the IRS uses a computer program called the Discriminant Function System to score tax returns based on experience with similar returns in the past. Taxpayers are also selected as part of a random sample and document matching. Document matching is when documents provided by your employers or clients (W2s and 1099s) are matched to your tax return to check that you reported them.

A tax audit does not mean you have made a mistake or tried to cheat on your taxes. In some cases, the review results in refunds to the taxpayer or an acceptance of the original return without changes. This is particularly the case when taxpayers hire professionals to represent them.

For instance, in 2019, 26,000 audits resulted in additional refunds to taxpayers totaling $8.9 billion (source). Of course, you should still do everything you can to avoid an audit in the first place. And there are things you can do to reduce your chances of an audit. (Read this article on 15 Flags the IRS Uses to Profile Taxpayers)

The IRS can audit tax returns even after it has issued a tax refund to a taxpayer. According to the statute of limitations, the IRS can audit tax returns filed within the previous three years.

IRS audit triggers

Any number of factors can trigger a taxpayer audit. Here are some of the most common factors that can trigger an audit:

IRS Audit TriggerDescription
Make a lot of moneyIf your annual income is more than $200,000, you have a 1 in 38 chance of being audited. Make more than $1 million? Congratulations, but you may want to keep your accountant on speed dial. There is a 1 in 10 chance the Internal Revenue Service will audit your income tax return.
Income discrepanciesThe IRS checks the income employers and customers claim to have paid (1099s and W2s) and what taxpayers report on their income tax return.
Aggressive deductionsIf you claim more deductions than the average for people in your income and business type, prepare to be audited—no big deal. Just make sure you can justify those deductions.
Business owners and self-employed workersWhen your home place of business is your home office, red flags get raised due to deductions the IRS says are questionable. You are three times as likely to get audited if you are in this category. Check tax laws, look at your return, verify your information, and keep copies of the returns filed.
Take large charitable deductionsThe IRS knows what the average person in your income bracket donates to charity. If you stand out, the IRS will check your numbers. By all means, be generous. Just make sure you keep your receipts.
Claim rental lossesThe tax code gives generous deductions for rental losses, but the IRS does make a point to check the legitimacy of sizeable rental loss deductions.
Write off a loss for a hobbyIt’s okay to enjoy your job, but you better be able to prove your business has at least the expectation of making money. The rule of thumb is you make money at least three out of every five years.
Fail to report a foreign bank accountIf you have forgotten to claim a foreign bank account, the IRS is currently offering amnesty to people who come clean.
Claim they use a vehicle completely for business useUnless you are claiming a deduction on a tractor, it is unlikely the vehicle is only for business use. This is an easy win for an IRS auditor.
Take an early payout from their retirement fundWithdrawals from a retirement fund before age 59 and ½ can trigger a 10 percent penalty. The IRS likes to check you haven’t forgotten to declare retirement payouts.

The best way to avoid an audit or to be prepared to deal with one is to hire a certified professional to prepare your taxes. This is particularly important if you are filing late returns.

What does an IRS audit process look like?

If you are being audited, you must understand how the process works and the best tax relief options available to you.

  • Audit notification: If the IRS chooses your tax return for audit, they will notify you by mail or phone.
  • Audit appointment: The IRS may ask to interview you at your workplace, at an IRS office, or by mail.
  • Documents required: The IRS will notify you in writing regarding what records they need. Auditors commonly use an Information Document Request, or IDR, to request documentation formally. You must retain your tax records for three years after filing your taxes. Only provide documents related to the years under examination. If the IRS requests items in the IDR that could incriminate you, you are in your right not to furnish them and wait to see if the auditor pursues it. The auditor will either let it go, not notice, or issue a summons.
  • Audit outcome: An audit may result in no changes, changes with which you agree, or changes with which you don’t agree. The auditor will explain any proposed changes to you.
  • Summons: A summons is a legally enforceable order that you should not ignore. However, if the summons orders you to present documents that could incriminate you, is vague or unduly burdensome, or breaks attorney-client privilege, you may be able to raise legal objections to the summons. Consult with a professional before replying.

If you agree with the audit results, the IRS will have you sign the examination report or similar form depending on the audit conducted. If you owe money, you will need to choose the payment option that works best for your situation. If you disagree with the audit results, you may request a meeting with a manager for further review of your case. Also, you may request an appeal.

What are different types of IRS audits?

The IRS makes the final determination of what audit method to use. There are three types of audits:

  1. Correspondence audit: This review is for less complicated audits that can be completed by mail. Most audits (seven out of every ten) are correspondence audits.
  2. Office audit: You’ll need to take your receipts and other documents related to specific questions about your return to a local IRS office.
  3. Field audit: An IRS agent comes to your home or place of business to conduct the field audit.

How long do IRS Audits last?

The length of an audit depends on the type of audit and the issues involved.

Correspondence audits take an average of two to four months to finish. For office audits, the initial appointment takes two to four hours, but additional appointments may be required. Field audits start with an initial meeting that several days to complete, but some cases require additional follow-up.

Regardless of the type of audit, you have the right to retain a tax attorney to represent you when dealing with the IRS. Only professionals authorized to practice before the IRS qualify. These include an attorney, a Certified Public Accountant (CPA), an enrolled agent, or an unenrolled tax preparer.

Taxpayers who hire a tax professional to represent them can file a Power of Attorney and Declaration of Representative (IRS Form 2848). A power of attorney is only for your tax proceedings. Only consider tax relief companies that employ tax attorneys, CPAs, and enrolled agents who will best understand the tax laws.

What to do if your tax returns get an IRS audit

Being selected for an audit does not necessarily mean you are in trouble. Typically, taxpayers “win” nine percent of field audits and 12 percent of correspondence audits with no changes to tax liability. Here are some tips on how to act when facing an IRS audit.

Be responsive

It is still important to act quickly and address any issues. Acting promptly will help you avoid or minimize hefty penalties and interest. The IRS will try to schedule an appointment within two weeks. If you ask to postpone the meeting for more than 45 days, the IRS collector will need to ask a supervisor for approval.

If you believe the audit will involve a large debt or tax evasion charges, contact a tax professional as soon as possible. Time is of the essence when dealing with the IRS. The IRS doesn’t play games with tax fraud and has a conviction rate of over 80 percent.

On the other hand, if you are dealing with a simple, low-risk audit, such as a request for receipts to justify large deductions or a small debt due to a math error, you may be fine dealing directly with the IRS yourself. Just remember you have the right to interrupt an audit at any moment and say you want to consult with your tax professional before continuing with the audit.

Arrange a review

Once you arrange an appointment, your handler will send a confirmation letter with the date, time, and location you agreed.

You will also receive an Information Document Request Form 4564 detailing the records the auditor wants to review. Remember that just because and IDR Form 4564 requires a document doesn’t mean you should provide it. Consult with a tax professional before furnishing documents or information that could incriminate you.

Warning

Never send or leave an original copy of a document. If a document gets lost in a sea of paperwork at your auditor´s office or gets lost in the mail, it will be your word against the IRS. During an audit, the burden of proof is on you, the taxpayer, and you need those documents to prove your claims.

Prepare and research

Carefully review the tax return under audit. If you used a tax preparer, ask for their assistance. If you filed yourself, hire a tax professional to review your return and identify what may have triggered the audit.

Organize your personal and business records. Find all the receipts and documents you used to file the return. You are required to keep records for three years from the date you file the relevant tax return. Business assets are an exception. Keep receipts on business assets for as long as you claim depreciation on them. Hiring a tax professional to put your records in order before the first appointment with an auditor can help set the tone you want for the rest of the audit.

Research the relevant Audit Technique Guide (ATG) for your industry. The IRS publishes detailed guides for its agents to help them audit certain businesses such as estate agents, attorneys, child care providers, hair salons, and car wash centers. ATGs are publicly available on the IRS website and provide useful information such as the questions you are likely to be asked and the income estimation methods agents will use for your industry.

Understanding an IRS Audit Letter

Here’s an IRS Audit Letter Sample (PDF)

Audit_Letter

IRS audit letters provide taxpayers with information and instructions on how to proceed with the examination. Make a copy of the audit letter and send it to your tax professional. Keep the original in your records for safekeeping.

The letter specifies the purpose and the documents required to complete the examination. It will also detail how much time you have to provide the requested information.

How should you act during an IRS Audit?

The IRS trains its auditors to pay special attention to the initial interview to assess your overall financial situation. Be polite, calm, and confident. Remember, you are as much under examination as your return.

Never lie to or try to mislead an IRS agent. Auditors like to ask questions that they already have answers for to assess your reliability. If there is a question you don´t want to answer, it is preferable to say you don´t remember or that you will have to check. Keep your answers short and precise. Agents will often create silence or review your documents without saying a word hoping to unsettle you. Don´t talk more than you strictly have to.

You can also buy time and deflect questions by answering with a question. You can ask which specific documents, w 2, business, or personal finance records they want to see. You can ask why they would like a particular document or information. It is your right to know why information is required and how it relates to the audit. You can also explain that you need to check for information or consult with your tax professional for difficult questions.

Consider hiring a tax relief company and ask that a tax attorney attend any meetings. This is particularly helpful when the stakes are high and you owe a large amount. An experienced tax attorney or CPA will know what questions to answer freely and when to stonewall an auditor on a fishing expedition.

How far back can the IRS audit a tax return?

The IRS will not audit returns older than six years. Typically, they will not audit returns older than three years. The vast majority of reviews are for tax returns filed in the last two years. However, if you omit 25 percent or more of your income or the IRS suspects tax evasion, the statute of limitations is extended to six years.

In some cases, the IRS requests taxpayers to voluntarily extend the statute of limitations to give it more time to audit an account or return. You can deny the request, but the IRS may base its audit on its information, which is usually bad news for taxpayers. Consult with a tax attorney before agreeing to an extension of the statute of limitations. Although agreeing to an extension is often the best move, there are times when it is smart to wait out a statute of limitations.

What are the chances of being audited by the IRS?

The odds that your returns will be audited vary widely depending on your income, whether or not you own a small business, what deductions you claim, and even where you live.

The good news is that for the vast majority of taxpayers, the chances of being audited are slim. In fact, 99.6 percent of personal returns were not audited.

If you are not self-employed and don’t own a small business, your odds are even better. Only 0.3 percent of personal returns without a Schedule C are audited. Typically, the less you earn, the lower your chances. To illustrate, a taxpayer who didn’t file a Schedule C (not self-employed) and made $60,000 a year would have a 1 in 189 chance of getting audited. The same taxpayer with a $250,000 income has a 1 in 65 chance of receiving an audit notice.

How do I write a reconsideration letter to the IRS?

Once an audit is complete, the IRS will send you a report with the examination results. If you disagree with the IRS audit results or additional taxes levied, you may have the right to request an audit reconsideration.

The first step is to review the report and the attachments from the audit very carefully. Determine which items in the report you think are incorrect. Hire a tax professional to assist you.

Collect any documents that can support your case. Check that the evidence you want to send was not part of the original audit and applies to the tax year that was audited.

Send a letter to the address on your audit notice. Explain you want the IRS to reconsider the audit and specify the changes you want them to make. Attach a copy of the examination report (Form 4549) and copies of the documents that prove your claims. Do not send original documents.

Consult with a tax relief company before sending an audit reconsideration application. There are circumstances when you don’t have the right to file for a reconsideration. For example, if you already agreed to pay the tax balance by signing a Form 906, Closing Agreement, an Offer in Compromise, or an agreement with the Office of Appeals, you have already forfeited your right to an audit reconsideration.

How much are IRS audit penalties?

An increase in your taxable income is not the only thing you have to worry about during an audit. Auditors can also hand out penalties to taxpayers that don’t follow IRS regulations.

This is a list of the main penalties you can receive as a result of an audit:

Deposit penalty: If you fail to deposit on time, you can be fined 2-15 percent of the amount, depending on how late you are.

Filing late: Taxpayers who file late can receive a penalty of 5 percent of the tax due. The penalty is charged every month the return is not filed, up to five months.

Paying late: Taxpayers who are late paying their taxes can be charged 0.5 percent of the unpaid tax every month up to a maximum of 25 percent.

Incomplete return: Taxpayers can be charged $20 a day up to a maximum of $10,000 if your income is below $1 million a year and $50,000 if your income is over $1 million.

Penalty on tips: Taxpayers who don’t report their tips on a tax return could be fined 50 percent of the Social Security tax on the unreported tips.

Frivolous tax return: Want to try your luck at invoking the First Amendment as an argument for not paying taxes? Think only foreign-source income is taxable? Prepare yourself for a $5,000 frivolous tax return penalty.

Misstating property value: If you overvalue donated property by 200 percent or more, you may have to pay a 20 percent penalty. Overvaluing property by 400 percent may result in a 40 percent penalty.

Civil fraud penalty: If an audit uncovers evidence of fraud, you may be charged with civil fraud and hit with a 75 percent penalty on any tax underpayment.

Negligence: Failing to keep records and substantially understating your income could result in $5,000 or 10 percent of the tax that should be on the tax return, whichever is greater.

Summary

Being audited by the IRS gets stressful. A notice of examination from the IRS can have the toughest taxpayer shaking in their boots. But it doesn’t have to be that way. In some cases, an audit results in no changes or even in a larger tax refund. Although it is technically possible to represent yourself, this is not a good idea when you may be charged for tax evasion or a large tax debt is at stake. You have the right to hire a tax representative. Exercise it.