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Understanding the Audit Process
What is an audit
There are many types of audits. The type of audit that most people are afraid of is the in-person audit. People imagine this as a scenario where the IRS invades your home or business and rummages through your personal files. This rarely happens. In more than 2 decades of representing clients before the IRS, I have only had to appear in person at an IRS office a handful of times. These instances have all been larger dollar returns that have something nonstandard. In every case the process began via mail and fax. Only after the auditor was unable to dig through and understand the documentation, were we asked to sit down with the auditor to explain it clearly.
The most common type of audit is a letter audit. The IRS wants you to provide documentation or a justification for something that has or has not appeared on your tax return. You (more preferably your CPA) prepare a response to the IRS's inquiry in written form, with supporting documentation and sends it to the IRS auditor. They review, and close the audit. Hopefully, with no changes.
Sit down audits are usually requested when the taxpayer has a large amount of documentation that the auditor wants to examine in person. In my experience, the auditor may also want to observe the taxpayer in person while they ask questions and have you manually pull documentation that they select on the fly, to see how well organized your files are. I cannot prove their motivations but this is my experience with these types of interactions. Being able to quickly pull sampled documents in person is very powerful for the taxpayer's case. Also, being represented by a professional is also very powerful. Often times with in person meetings I do all of the talking for my clients. This is their right.
How returns are selected for audit
According to the IRS, many returns are selected randomly, and selection for an audit does not always mean they have determined there is a problem with your return. The easy answer to 'how was I selected for an audit?' is that a computer does it. Once your return is entered into the IRS system it receives a score called a Discriminant Function System (DIF) score. The score is related to all of the different income and expense types on the tax return and how the matchup with similar returns. In addition to this score, you are higher risk for an audit if you participate in potentially abusive tax transactions, or are involved in business or real estate transactions with other people that get audited.
Most personal tax returns that include simple transactions such as W2's, 1099-R's, 1099-INT's, 1099-DIV's, and basic stock transactions are usually very easy to match to the IRS reporting systems and represent a low possibility of audit risk. Not that you cannot be audited, but it is unlikely that it will result in any changes to your return. All of the forms previously mentioned are reported to the IRS as well as sent to the taxpayer for the purposes of preparing their return. When the return is received by the IRS, the scoring system compares all reported income to the return, and looks for unreported, or under reported income. Failing to include reported income usually triggers a letter from the IRS with an adjustment. This can be corrected by responding to the letter, explaining the differences, or the purpose for not reporting income. If the explanation is accepted by the IRS, the issue is resolved. This is not an audit.
What can you do to avoid an audit?
The simplest way to avoid an audit is to have a simple tax return. However, most people cannot choose to do this. As life gets more complicated, often our tax returns get more complicated. You can avoid doing business transactions with disreputable people, or participating in complicated transactions without first getting solid tax advice from a professional. Less than 1% of tax returns are audited each year. The IRS's previously stated goal has been to audit upwards of 3% per year, but that has never happened. However, the computer system specifically identifies complicated transactions, and business activities that are open to opportunities for abuse of the tax code.
(A previous client of mine was in an industry that put him in a position to do a lot of schmoosing. In order to maintain client relations, he would through lavish parties to entertain existing and possible clients. These parties were treated as either 'entertainment' or 'advertising/promotion'. The parties were legitimate, but the expense was far outside of normal percentages for companies of his type. He was audited, and the IRS stated that the amount in this category is what triggered the initial audit. We had all of the appropriate receipts, ledgers, statements, calendars, client names, and backup research of IRC code to confirm that these expenses were legitimate. We succeeded, regarding this audited item.)
How to prepare for an audit
The key to succeeding in an audit is to make sure you can prove everything that you reported on your tax return. As you are gathering information for your tax return, you should keep copies of all documents:
- Keep copies of all official tax forms that have been given to you, and used on your tax return.
- Keep copies of all receipts for expenses and deductions. Make sure they are well organized.
- If you have businesses, or rentals, you should keep accounting records that correspond to your receipts. They should be organized by type so it is easy to match the totals to the tax return categories.
- If you are reporting any vehicles expenses, you should have a mileage log (this is always required and requested by the IRS).
- If you are claiming any travel, you should have a calendar listed dates, clients, and purposes for travel.
- If you have participated in real estate sales or exchanges, you should have historical purchase and sales documents to prove the basis of the property.
- Keep copies of any IRS guidance, IRC code or other research that you have done to substantiate specific deductions or tax strategies.
This should not need to be said, but if you are audited, the best way prepare is to not have done anything you cannot justify. So, the best preparation is being honest in all of your reporting.
How to beat an audit
It is highly recommended that you do not attempt to respond to an official audit on your own. Especially, if you do not fully understand what they are questioning, or the ramifications. You may mistakenly give the auditor too much information that may either cause them to open up a larger audit, or hurt your cause. People often think that being personable or 'open and honest' with an auditor, will help them. It is natural to want to appeal to the person you are working with to resolve the situation, but it is unlikely to help you. Auditors are low level functionaries in a red tape ocean. They get paid to use every bit of information you provide them against you.
Using a professional to represent you, puts distance between you and the process. This is similar to how a criminal will use the services of a lawyer to represent them in court. Also, the IRS deal differently with tax professionals and Certified Public Accountants (CPA's) differently than it deals with taxpayers. In many cases the CPA is better trained, and researched than the auditor, and can present information in a way to defend the reported information.
(A taxpayer had a husband with very high vehicle expenses related to a business activity. This triggered an audit and the husband soon became sick and died before the process was complete. The taxpayer thought this would end the process, but it did not. The taxpayer continued to use the husbands notes to respond to the IRS's requests. This went on for 18 months. After speaking to a friend, she contacted Bowen Accounting. We reviewed the notices from the IRS, and the client documentation after reformatting the same information and issuing a response to the IRS, citing tax code, the matter was resolved in less than a month.)
Our company deals with tax issues, documentation, and IRS notices regularly. Having someone on your side, that can help you understand the process and act on your behalf is usually very comforting, and can save you a lot of money. Let us help you, by doing what we are good at.
What if you lose?
I have dealt with unreasonable auditors in the past, that were unable to understand our documentation or disagreed with our interpretation of tax code. I have usually escalated to their superior before they could close the audit, and in almost every case found a way to successfully negotiate a reasonable end to the audit. However, if this is not possible, you can appeal an auditor's conclusion after they have closed the audit. This allows you to have the entire audit reviewed at a higher level and may or may not include a court hearing. There are strict deadlines related to this process.