What is a Tax Audit?
A tax audit can be an extremely difficult process without an experienced tax professional. If you receive notice that the IRS is auditing your taxes, a professional may be able to help you file an audit reconsideration.
In this article, we’re exploring one of the most common questions we hear from people – what is a tax audit?
Every government has a tax gap. This is a gauge to measure compliance and figure out, through a gross estimate, how much money is currently owed in taxes and left uncollected. It has historically fluctuated between 15 and 18 percent of total tax liability.
Tax audits are one of the ways in which the IRS attempts to collect on missing tax liability, usually by scouring for obvious and extreme discrepancies or red flags and investigating with varying degrees of urgency depending on the nature of the inconsistency, and the potential for collection.
Because of several factors, including waning manpower, tax audits are relatively rare. Only about 0.59 percent of all individual returns were audited in 2018, dropping off considerably in recent years.
That number goes up to 3.52 percent among taxpayers earning more than $1 million a year and remains under 1 percent for anyone earning less than $500,000.
Furthermore, the majority of tax audits are performed wholly through correspondence – they’re straightforward, and don’t involve heavy scrutiny. That being said, if you have been notified of a tax audit, it helps to know why you might have triggered one.
Defining a Tax Audit
The IRS defines a tax audit as an examination of an individual or organization’s accounts and information to ensure that they’re paying the right amount of taxes. In most cases, the IRS is checking to make sure people and businesses with red flags aren’t accidentally or unknowingly underpaying, or purposefully committing tax fraud.
What Triggers a Tax Audit?
Tax audits are statistically much more likely the more money you earn, becoming far more common once your annual income reaches $1 million or more. However, most tax audits are performed on account of these reasons:
- Statistics and Averages
The IRS screens tax returns using computer software, looking for incomplete or inconsistent information, usually by referencing to other similar returns. If a return claims to have earned far more or far less than others with similar information and in the same profession, or if they have claimed extraordinary losses and are still in business, or have claimed far more deductions than the average person in the same field, an automated program may pick a return out for human review. Sometimes, returns are chosen at random.
Human auditors will then sort through any unusual returns, accepting ones that seem consistent or passable on a second glance, and filing others away for review if they are otherwise suspicious. At this point, the IRS may decide to contact the taxpayer for additional information.
- Guilt By Association
When the IRS obtains information that a person has been engaged in illegal activity and/or has been committing tax fraud, anyone associated with them, or anyone who has done business with them/received payments or investments may be audited as a result.
You may not have been aware of this party’s illegal activities, but the IRS will review your information nonetheless to gather evidence.
- Math Mistakes
If you file your own taxes, chances are that you might’ve made a simple math mistake. If this is the case, the IRS will usually send you a math error notice.
To explain just how common this is, the IRS discovered 2.17 million math errors in tax returns in 2015, and as a result, sent out 1.67 million math error notice letters. This is covered in the Internal Revenue Code under Sec. 6213(b).
Most math error notices are sent out automatically, and may not have even received much scrutiny from a human. The IRS will usually send a correction and ask you to pay what is owed/inform you that you have been issued a tax refund, if you paid too much.
- Strange Deductions
Tax deductions are amounts you can deduct from your total tax liability at the end of each year based on a variety of different conditions, including charitable donations, work-related deductions, and investment-related deductions.
However, if you have made far more deductions than the average person in your profession, area, and tax bracket, the IRS might flag your tax return for human scrutiny, and contact you with a request for more information to justify your deductions.
- Suspiciously Round Numbers
While this might seem like a strange trigger, the IRS can be a stickler when it comes to accuracy. They don’t expect every expense and paycheck to be a perfectly round number, and while there might not be much harm in rounding up or down to the nearest dollar, avoid turning $27.75 into $30, and other similar little additions and subtractions.
- Excessive Losses
Some people make it a habit of taking the term “business expense” quite liberally – to the point that they report excessive losses and expenses, which again, can be very suspicious. At some point, the IRS will ask itself how you manage to keep your business afloat with all these hits.
- A Home Office Deduction
On the surface, a home office deduction may be sensible for most people working from home at the moment, particularly given the state of the world. But in practical terms, the “regular and exclusive use” requirements of a home office deduction require you to effectively prove to the IRS that the portion of your home dedicated as a home office is just a home office, and nothing but.
Anything indicating personal use may violate the IRS’s definition of what a home office is, and may land you in some hot water. Consider taking up the question with a tax professional to make sure your home office setup applies for a deduction.
How the IRS Conducts Audits
The IRS typically conducts audits entirely via mail, or via in-person interviews. This is relatively rare, however, especially given the limitations presented by the ongoing pandemic. To learn more about the methods the IRS may use to perform a tax audit, refer to the Audit Techniques Guide. Know that you have a right to ask the IRS why it’s asking for certain information, and the right to appeal.
The IRS may ask you for a number of documents needed to prove that your tax return is accurate, including receipts, ownership proof, and other records and documents. Note that you are required to keep any and all records pertaining to your tax return for at least three years from the date the return is filed. Again, it might be a good idea to contact a tax professional if you feel the need for representation during a tax audit.
What Happens After an Audit?
When the IRS has concluded its audit, it will let you know of its findings and declare that you either: change nothing (the audit found no discrepancies upon further investigation), or comply with changes the IRS proposes.
If you choose to comply, they will ask you to sign an examination report. If money is owed, the IRS has several ways of collecting.
If you choose not to comply, you can file an appeal through the IRS’s Independent Office of Appeals, or request to speak to an IRS manager.
Contact a Tax Professional
Depending on the complexity of your tax situation and the results of the audit, it may be in your best interest to contact a tax professional. Most of the time, the IRS is simply aiming to minimize the tax gap, and find out who may be committing fraud.
But IRS agents are only human, and while courteous, they may make mistakes, or potentially request changes on the basis of misunderstanding or incomplete information.
By working with a tax professional from day one, you can be sure that you’re properly cooperating with the IRS and avoiding any undue or surprise taxes, or minimize the impact of an audit.