I’ve had extensive experience representing all kinds of people and small businesses during an IRS tax audit. I’ve observed common mistakes made on tax returns and I learned which of those mistakes get flagged for an audit. I’ve put together what I learned to help you better understand IRS tax audits and how to respond to them.
What’s an IRS Tax Audit?
An audit by the IRS is a review of financial and tax information. It can be performed on an organization’s or an individual’s returns. It’s used to verify accuracy in income and taxes reported.
What Are the Different Types of Tax Audits?
Correspondence audits deal with the simplest issues, usually just requiring documentation or further clarification. Office or in-person audits are slightly more involved. You or your tax preparer must visit an IRS office with your return and records. Field audits are when an IRS examiner or Revenue Agent comes to your home or business to look at your records and operation.
What If You Receive a Notice for an In-Person Audit?
Open the notice immediately, and read it. There is a time limit to respond. You can handle this notice in one of two ways:
- You can decide to handle it yourself, in which case you should call the phone number on the notice and schedule the audit appointment.
- You can ask a tax practitioner to represent you at this audit. Call this professional, and provide them with all necessary documentation. To find an accountant in your area, search our ProAdvisor database.
Unless you’re concerned about criminal issues, you don’t generally need a tax attorney. If you hire a professional, you’ll need to sign a power of attorney form so they can work with the IRS on your behalf.
What If You Receive a Notice for a Correspondence Audit?
Treat this in the same way you would treat an in-person notice. But in this case, don’t pick up the phone to call the IRS. Instead, make a note of the “respond by” date, mark it on your calendar, and get to work.
Get your records in order. If you’ve maintained proper books and records, you should be in good shape, but if you haven’t, hire someone to help. If you’re using QuickBooks Self-Employed, scan or upload documents to support each transaction. Save those electronic files—preferably forever, but at least for 10 years to be safe.
Keep copies of all tax returns that you file. In that file, keep a copy of every document and worksheet you used to support that tax return. Your tax professional will give you back your copy of the returns with your original documents, W-2s, 1099s, etc.
How Do You Prepare for an Audit?
In all cases, whether you’re working with a tax practitioner or doing it yourself, you need to gather all the records. You may be able to get everything you need from your online accounts if you don’t have the original papers handy. You’ll almost always need the following documents in an audit.
- Bank Statements and Copies of Cancelled Checks
Save copies of bank statements and cancelled checks for all 12 months and for every bank account (checking, savings, PayPal, Google, Amazon, etc.). If you also have copies of the deposits, that would be very helpful, especially for transfers between accounts. Do a spreadsheet on each account to show all the deposits. Identity transfers between the accounts and non-income deposits.
- Credit Card Statements
These will help support the deductions you’re claiming on your tax return. Use that as a starting point to gather copies of receipts. If you don’t have the receipts for your significant expenditures, call the credit-card companies and ask them for copies. Make sure you have itemized documentation for what you’ve reported as business expenses; just showing a charge at Office Depot doesn’t mean it’s a business expense. And be sure to have receipts for all your asset purchases (e.g. vehicles, furniture, fixtures, equipment, etc.)
- Government Filings
- Payroll tax returns
- Sales tax returns
- Excise tax returns (if applicable)
- Property tax returns (personal or real property)
- City/county business license reports
- Anything you file on a monthly, quarterly or annual basis for any government agency
Pull copies of the original policy summary. Be sure to outline what each policy is for, and clarify whether each is really a business deduction. Here are some high-level guidelines:
- Personal life insurance generally is not deductible
- If you used the “Actual Method” to claim a deduction on an automobile, you can write off your auto insurance fees
- Business liability policies are deductible
- If you claimed a self-employed health insurance deduction, your health insurance expenses are deductible. (Note: Medicare premiums do count toward this.)
Your tax practitioner will tell you what else you need. And the IRS IDR (Information Document Request) will tell you what else you need to collect.
What Should You Do After the Audit?
If the audit went as expected, you have nothing more to do. Just put everything away.
If you owe some money and agree with the balance due, pay it when you get the bill. If you can’t afford to pay right away, you can set up an installment agreement with the IRS.
If the audit shows you owe a lot of money, and you don’t agree with the determination, you have a lot of options. You can file for an appeal, request mediation or go to tax court. All of these options are open to you without your having to pay the balance due. But each of these protests have a specific deadline. Miss the deadline, and you’ve lost some rights. IRS Publication 556 explains your options.
What Are the Penalties for Under-Reporting on Your Taxes?
When the IRS disallows a lot of your expenses or finds a lot of unreported income, they often charge penalties. Most of the time, a good tax pro can persuade the IRS to waive the penalties for under-reporting. However, they generally cannot get penalties waived for late filing and late payment, including late payment on new balances resulting from an audit, so be sure to pay on time or request an extension by the deadline.
That being said, if it’s clear that the under-reporting of income or the over-reporting of expenses was deliberate, you will face penalties starting at 20% for accuracy-related penalties. They can go as high as 75% for fraud. And when the IRS feels you were evading taxes, the penalties can even include jail time. That’s when a criminal tax attorney is a good idea.
If you have under-reported 25% or more of your income, or if your taxes were under-reported by 25% or more, the IRS can audit you for six years instead of being limited to three years.
How Can You Avoid Being Audited?
You need to do four key things. First, keep great records and don’t make up the numbers you put on your tax return. Second, make sure everything on your tax return is in the correct place; put things in the wrong place and it confuses the IRS computer, which may get you flagged. Third, make sure you report all the income shown on all 1099s you receive. Even if the 1099s are wrong, there are ways to fix the errors in the return itself so that you don’t pay too much tax. Lastly, use reliable accounting software and consult an accountant to ensure all of your income, expenses and documents are on-point.