A tax audit is an examination of an organization's or individual's tax return. Each year when tax season rolls around, the Internal Revenue Service, as well as state departments of taxation, kicks into overdrive to meet with the onslaught of tax filings. The purpose of a tax audit is to verify that the financial information is being reported correctly.
How tax returns are selected for audit
Americans filed more than 186 million tax returns in 2011. The Internal Revenue Service examined, or audited, about 1.6 million of those returns — less than 1 percent. The odds of being audited are slightly higher for individuals who make less than $25,000 or more than $200,000.
Being selected for an audit does not always mean that you've made an error in your return. Most returns are chosen at random by a computer. The IRS has several criteria to determine a tax filing’s eligibility for an audit. Below are just a few ways the IRS detects errors:
The Information Returns Processing System (IRP): This computer system handles all data received from entities required to report taxpayer income. This includes employers, banks, brokerage forms, Medicare, Social Security and all other organizations required to report taxpayer information. The IRS will then run the information provided by these entities against what was entered on a tax return.
The Discriminant Inventory Function System (DIF): Each tax return is given a DIF score, which determines how accurate a tax return is likely to be. The higher the number, the more likely a return is to be audited. The algorithms used to determine this score are based on hundreds of variables, though deductions and exemptions carry the most weight in determining this.
The Unreported Income Discriminant Inventory Function System (UIDIF): This system looks at different areas from the DIF and rates a return on its potential of having unreported income. The formula used for this is simply a comparison of income to expense ratios. If a person spends more than they make, this is a red flag to the IRS.
Audits of related entities: If the IRS received a tax return involving transactions with other taxpayers, either investors or business partners, and the return has errors on it, the IRS will select all affected tax returns for audits.
Types of audits
Once a tax return is determined an eligible candidate for auditing, the IRS will send you a letter making the announcement of an audit. The type of audit you’ll be required to do typically falls into one of three types:
Correspondence audit: The most common of audits, this typically entails mailing specifically requested documentation to the IRS.
Field audit: For individuals or businesses who’ve earned more than $100,000 in income, the IRS is more likely to send an IRS agent to your home, place of business or tax professional’s office.
Office audit: Sometimes the IRS requires you to attend an IRS facility and meet with an auditor. The factors influencing this type of audit vary.
Avoiding an IRS tax audit
You can do a few things to reduce your chances of being audited. These are pretty straightforward, but some people overlook the obvious during their tax return preparation.
Check and double-check. The most important thing to do to avoid an audit is to make sure your return is correct. Check that your personal information, such as address and Social Security number, is correct. Double-check your math. [Your Smooth Tax Season Next Year Starts Now]
Keep good records. Good records help you organize and accurately calculate your return. Records also provide proof for your deductions. [10 Crazy Tax Deductions Allowed by IRS]
Reduce expenses. Eliminate or reduce business expenses related to entertainment, food and your car. These three items raise red flags with the IRS because they are often personal rather than business expenses. If you do report them as business expenses, make sure you have documentation. [10 Ways to Make Tax Season Easier]
After an audit
Once an audit has concluded and you’ve either met with an IRS auditor or sent in the requested documentation, you will receive the IRS Form 4549. This is the IRS examination report and will show any changes to your tax liability. Explanations will be given for changes or adjustments and the final return (or deficient) amount will be indicated. If the report states you are due a refund, then no action is required on your part.
However, if the report finds you owe money, this will include additional taxes in addition to interest and penalty fees. In the event of this, you have two options: approving the changes or disputing them. If you approve, then you’ll simply need to sign and return a copy of Form 4549 in addition to Form 870, which gives your consent of the tax adjustment. You will likewise need to pay any tax deficiencies and penalties as they apply.
Disapproving the audit findings requires you to do one of the following:
- Provide additional documentation for consideration
- Request another meeting with the IRS examiner to discuss the audit’s findings
- Meet with a group or senior manager to discuss the audit’s findings
- Request an appeal
Whether you choose to approve or disapprove of the audit changes, you’ll only have a window of 30 days before the IRS considers your case disapproved. After that, the IRS provides another 30 days before the findings are finalized.
While being audited by the IRS feels quite frightening, the process is quite painless if you’ve made a good habit of documenting all expenses reported on a tax return. When you make a habit of reporting deductions you have no proof of, the IRS can be a most unforgiving entity. Overall, the IRS is in place to ensure the fair treatment of taxpayers and IRS audits are the only way of ensuring everyone plays fairly with their tax returns.
Further reading and tax advice: