- A tax audit is an examination by a taxing authority of your tax return information to ensure all reported data is correct.
- The four kinds of tax audits are field, correspondence, taxpayer compliance measurement program and office audit.
- Incorrect data or incomplete tax returns can trigger an audit.
- This article is for small business owners who want to learn the best ways to avoid a tax audit and what they should do if they receive an audit notice from the IRS.
Few things can potentially sound as ominous as notice of an audit by the IRS or other taxing authority. It may not be as bad as you fear, however. The idea that an audit is always an extended ordeal with a negative outcome is a common misconception. The truth is an audit doesn’t necessarily mean that an IRS agent will show up at your door or you are in some kind of tax trouble.
Here’s what you need to know about tax audits, what you should do if you’re audited and how to lower your chances of being audited in the future.
What is a tax audit?
A tax audit is an examination of an organization’s or individual’s tax return to verify that financial information was reported correctly. Tax audits are performed not only by the IRS but also by state departments of taxation, payroll tax departments and other governmental agencies. [Related article: Best Payroll Services for 2023]
There are different levels and types of tax audits, ranging from simple requests for more information or documentation to an extensive investigation of your records. Being subject to an audit does not necessarily mean the IRS thinks something is incorrect. Unless you are a high-income taxpayer or you have unusual tax items or amounts on your return, any tax audit you are subject to is more likely to consist of specific questions, rather than a time-consuming review of your tax information.
What triggers an audit?
Most taxpayers have little reason to worry about an audit. In its 2022 Data Book, the IRS reported that continued resource constraints have limited the agency’s ability to address high-end noncompliance. The audit rates for individuals have fallen in recent years and, although the IRS plans to hire additional resources to address high-risk noncompliance (according to the IRS), it has no plans to increase the audit rate for households making less than $400,000.
Your chances of being audited may be higher if you have one or more of a variety of potential “triggers” in your tax returns. The IRS uses a computer scoring system, called the Discriminant Information Function (DIF) system, which analyzes tax deductions, compares taxpayer data and is often the basis for initiating an audit. The following triggers tend to raise questions and attract attention from the IRS:
- Income not fully reported; for example, total income is less than that reported on tax information forms.
- Unusual business operating losses.
- Lavish business expense deductions for meals and entertainment.
- Sharp drop in reported income from one year to the next.
- Exceptionally large charitable deductions.
- High income. “The majority of tax returns that are audited belong to taxpayers whose income is more than $500,000 or over $1 million a year,” said Adriene Raynott, senior business analyst at Cogneesol. “The chances of an audit increase when taxpayers try to wipe out their income through tax deductions.”
- Foreign bank accounts.
- Cash-intensive businesses, such as restaurants and convenience stores.
[Related article: Getting Audited? How to Handle It Like a Pro]
Factors that can trigger an audit include an incomplete tax return, incorrect information on your tax documents, large charitable deductions or having money in a foreign bank account.
All tax audits are not the same. The one you encounter depends on your situation, what the IRS gathered from your tax return and the items that are needed to resolve the issue. “The IRS selects returns for correspondence, office and field audits using return selection software,” said Dewey Martin, CPA, CMA, director and professor at the Husson University’s School of Accounting. “Details about this software are not available to the public. The software compares deductions and losses to income sources on filed tax returns to find outliers.”
The taxing authority will request one of the following types of audits.
1. Correspondence audit
With a correspondence audit, you receive a letter requesting a proof of statement or documentation to verify information on your tax return. This is the most common type of audit. You might receive this letter, for example, if you have high charitable contributions compared to your income.
“I had a client who was audited on this issue using the correspondence audit because the contributions were higher than her income,” Martin said. “Once documentation was mailed to them, there were no changes to the tax return.“
2. Office audit
Most tax audits do not include an in-person meeting. However, if you have several issues on your tax return that are beyond the scope of a correspondence audit, you or your representative may need to attend an in-person meeting with a tax auditor at an IRS office.
“Sometimes, this happens because a business operating as a proprietorship has some unusual transactions,” Martin said.
3. Field audit
This is a face-to-face meeting between an IRS auditor and you or your representative at your certified public accountant (CPA) or tax attorney’s office (or less ideally at your place of business or home).
“If there is inventory involved in the business, the auditor will usually want to observe the actual inventory and review inventory records at the business location,” Martin explained.
4. Taxpayer Compliance Measurement Program audits
For this type of audit, tax agents examine every item and event in your life that can affect your taxable income. This rare audit may mean you need to show your birth certificate, marriage license and other personal documents to check that all the paperwork you provided is actually from you and is reported accurately.
There are four types of tax audits: correspondence, office, field and tax compliance measurement program. Each one varies in degrees of verification required to resolve the issues in question on your tax return.
What should I do if I receive an audit notice?
If you receive a straightforward audit letter requesting more information or documentation, you or your tax professional can choose to respond by mail. Hopefully, the problem will be sorted out and that will be the end of it.
If the audit sounds more serious; for example, if a significant amount of money is involved, the issue is complex or you disagree with the IRS, be sure to get professional advice. Calling the IRS is not generally advised. Scott F. Berger, a CPA and principal of entrepreneurial services at the Boca Raton, Florida, office of Kaufman Rossin, said he generally advises against calling the IRS if you receive an audit letter. Berger said his clients often tell him that because they have nothing to hide, they want to pick up the phone and fix it. Based on his nearly 30 years as a CPA, Berger thinks that’s a bad idea.
“Generally speaking, nothing good ever comes out of that,” he said. “Yes, they have nothing to hide. The return is all on the up and up, but this person on the other side of the phone has a job to do and their job is to make sure the government collects all the taxes that it legitimately can.”
Berger also cautioned that IRS audit letters are always sent by postal mail. Phone calls or email notifications are scams.
Martin Press, a tax attorney with Gunster law firm, agrees that clients should not represent themselves in significant tax audits. As soon as small business owners receive an audit notice in the mail, they should contact their CPA immediately and, if advised, provide them with a signed power of attorney form (Form 2848). This authorizes a CPA, tax attorney or enrolled agent to contact the IRS and handle the audit, without the taxpayer needing to be present. He also recommends the audit examination be held at the CPA’s office, not your place of business.
Press said clients are always relieved when he informs them that they do not have to appear before the IRS ― either now or later.
“The IRS, many times, claims that they have to start out with an interview of the taxpayer,” Press said. “There is no obligation for a taxpayer to do an interview at the beginning of a tax examination. Under what we call the Taxpayer Bill of Rights, they may never have to give an interview with the Internal Revenue Service.”
Although taxpayers are not required to meet directly with the IRS, a detailed examination of a small business taxpayer is usually not over quickly; it often takes a minimum of six months to a year to resolve, Press said. If no resolution is reached, however, or if taxpayers wish to dispute the outcome of the initial audit, they do have a right to appeal it.
If you are audited for more than a simple request for information, do not handle it by yourself. Contact a CPA or tax attorney to represent you. Resolving a complex case can take from six months to a year, depending on your case.
How can I minimize my risk of a tax audit?
According to Berger, one of the best ways to reduce your chances of being audited is to keep good records. This ensures that if you are questioned by the IRS, you can substantiate deductions, income and other information. He recommended organizing bookkeeping systems to create a clear and accurate record of all transactions as well as maintaining and preserving the source documents used for accounting and tax preparation.
“The other thing I would recommend that somebody do is hire a bookkeeper,” said Berger. “Look at what it’s going to save you, not what it’s going to cost you.”
With the assistance of a knowledgeable bookkeeper or tax preparer, “issues will be vetted before they’re presented on a tax return,” Berger said. Accounting and bookkeeping professionals can also help substantiate and validate information reported to the IRS, he added.
Some people avoid taking legitimate tax deductions and credits to lower their chances of an audit. In most cases, you are better off taking the tax benefits and documenting how you qualify than by not taking benefits and paying more taxes than you should.
To avoid being audited, keep organized records of your finances using a bookkeeping or accounting system. When filing small business taxes, work with a tax professional to ensure your information is reported correctly.
How does understanding tax audits help you deal with them better?
The possibility of an audit may motivate many people to keep good records and use due care in preparing their taxes. However, for some people the fear of an audit goes further. These people may avoid taking tax deductions, credits and other perks to which they are entitled, for fear of triggering an audit. If they receive notice of an audit, they may become unduly worried, even to the point of not dealing with the audit as well as they should.
By understanding tax audits and how they work, you can lower your chances of being audited without losing legitimate tax benefits and, if you are audited, you can deal with the IRS and clear up any audit issues as quickly and positively as possible.
Sally Herigstad and Joel N. Sussman contributed to this article. Source interviews were conducted for a previous version of this article.