IRS Audit – Some Basics

Every day the IRS is conducting audits on individuals and businesses to ensure that they are in compliance with U.S. tax law. It is on the hunt for tax returns it believes were filed with incorrect information. It spends time in this endeavor for one obvious reason….lots of money is on the line. As a result, it has become the world’s foremost financial detective.

In order to help it find the money, it has developed systems that detect the returns that are most likely in need of attention.

Audit Systems

Computer Scoring

The IRS has developed compute programs that are able to give each return numeric scores. The unreported income score, for instance rates the return for the potential of unreported income. Once the computer rates the returns, employees review via eyeball power, the highest scoring returns. They pick from those high scoring returns the returns to be audited for that reason.

Information Matching

Many tax returns are picked for examination simply because reports submitted to the IRS like w-2 and 1099 forms don’t match the income reported on the return. These types of audits are common.

Related exams

Returns are often selected for an audit because they are related to transactions with other taxpayers like an investor or business associate.

Audit Statistics

The fear of being audited is widespread, but as you will see from the following statistics from 2009, a relatively small percentage of individuals and business returns are actually audited each year. The most interesting part of these statistics is that when the IRS decides to charge individuals with a crime as a result of an audit, the vast majority of those charged spent time in jail.

Some irs audit statistics from 2009:

1. Approximately 1% of all personal tax returns were audited. (1.46 million out of 138.8 million)
2. 22.8% of audits were conducted by IRS officers and the rest were handled primarily by mail and phone.
3. The audit rate for “high income” earners tripled from 2.3% to 6.4% ($200,000 per year to $1,000,000.00 per year)
4. The audit rate for high income earners was higher than the audit rate for those earning more than $1,000,000.00 per year.
5. 4,212 criminal investigations were launched as a result of audits.
6. 81.21% of all criminal investigations resulted in incarceration.
7. 26.39 million civil penalties were assessed against individual taxpayers
8. 54.71% of civil penalties were for failure to pay, 28.67% were for underpayment of taxes, and 14.42% were for delinquency.
9. 970,098 civil penalties were assessed against corporations

Avoiding the Audit

Based on the 2009 statistics, the chance that an individual will be audited randomly is lower, but the chance that you will be selected if you deserve it is up. The IRS gets better each year in the process of separating the “wheat” and the “chaff”.

Here are some tips for reducing the odds of audit.

1. Have a CPA or Tax Attorney prepare your return using tax software and sign it as a paid preparer. Audit risk increases for self prepared tax returns, returns prepared by non CPAs, tax returns prepared by hand and tax returns not signed by the CPA.
2. Make sure that the CPA or Tax Attorney is reviewing the income and expense figures for believability.
3. If you operate a business, try not to operate as a sole proprietorship, DBA or single member llc. The audit risk for these business forms is high.
4. Make sure that your tax return income matches all of the w-2, 1099 and other forms that may have been sent to the IRS.
5. Don’t estimate or round up numbers on the return.
6. Keep good records and report deductions based on those records.
7. Be careful when claiming employee business expenses and auto mileage.
8. File the return on time.
9. Read the rules for claiming Home Office Deductions closely before taking the deduction

Audit Process

An IRS examination can be done by mail or through an in-person interview and review of the your records. The interview can be held at the IRS office or the your home, place of business or the CPA/Attorney office. You can make an audio recording if notice is given. If the time, place or method that the IRS schedules isn’t convenient, you may request a change.

An audit notification letter will state what is being reviewed and what documents needed. Once the items are reviewed, the IRS will explain the reason for the proposed changes. Most taxpayers agree with the changes and the audit will end at that point.

Appealing the Audit Results

If you do not agree with the audit results you can appeal first by conferencing with the IRS examiner’s manager. If no agreement is reached with the manager, an opportunity to review the adjustments for 30 days exists. If no contact is made with the IRS during that 30 day period in writing, a document called a “Statutory Notice of Deficiency” is issued. You have 90 days to file a Tax Court Petition.

The U.S. Claims Court and the U.S. District Court do not hear cases until after the tax has been paid and the administrative refund claims have been denied by the IRS. The Tax doesn’t have to be paid to appeal within the IRS or to the Tax Court.

The case can be appealed further to the U.S. Court of Appeals or to the Supreme Court.

Audit Reconsideration

The Audit Reconsideration is a procedure designed to help those who don’t agree with the results of a tax return audit or the results of the IRS creation of a substitute tax return….AND who missed their chance to appeal initially.

During the audit reconsideration, the IRS will informally reconsider the tax.

If the you have already paid the tax debt, you must file a formal claim in order to initiate the audit reconsideration process. This claim is made using the form 1040x.

The IRS will accept the audit reconsideration if you submit information it has not yet considered.

Substitute Tax Return and the Audit Reconsideration

A very common Audit Reconsideration process is the filing of a “challenge” to the substitute tax return. The challenge is really a correct tax return containing new information regarding income and deductions which the IRS didn’t have available to it. Many taxpayers are able to reduce the debt they think they owe by thousands and sometimes hundreds of thousands of dollars as a result.