How an IRS Audit Works: Everything You Need to Know

No one ever wants to hear, “the IRS is auditing you.” But if you do receive that dreaded letter in the mail, don’t panic. An IRS audit can be intimidating, but knowing how an IRS audit works can help make things a little easier. We’ll discuss what triggers an audit, what happens during the process, and what you can do to prepare. Let’s get started!

What Is An Audit?

An audit is an inspection of an individual’s or organization’s financial records. An audit aims to ensure that the financial records are accurate and comply with applicable laws or regulations. Suppose you are selected for an audit. In that case, the IRS will notify you in writing and will provide instructions on how to proceed. The IRS will also request that you provide specific documentation, such as tax returns, bank statements, and receipts.

It is important to note that an audit does not necessarily mean that you have done anything wrong. However, it is vital to cooperate with the IRS and promptly provide all requested documentation.

What Happens When You Get Audited?

You should know that an audit is not a criminal procedure. The IRS does not have the authority to prosecute taxpayers for failing to pay their taxes criminally. Instead, an audit is simply a review of your tax return to ensure that you have reported your income and expenses correctly.

Suppose the IRS believes that you have underreported your income or overstated your deductions. In that case, they will send you a notice explaining their findings. You will then be allowed to provide documentation to support your position.

Finally, if the IRS still believes that you owe additional taxes, they will send you a bill for the amount due. You can appeal the IRS’s decision if you think that you do not owe other taxes. At the hearing, both you and the IRS will have the opportunity to present your case. The appeals officer will then decide based on the evidence.

If you disagree with the appeals officer’s decision, you can file a petition with the Tax Court. A Tax Court is a court of law that has the authority to hear cases involving federal taxes.

What Triggers An Audit?

The IRS has a few ways of selecting which taxpayers or businesses to audit. Sometimes, it’s simply random. Other times, the agency uses “discriminant function scoring,” which considers factors such as income and deductions claimed. The IRS might also look at a taxpayer’s history – for example, if they have been audited before.

Correspondence Audit

When it comes to tax audits, the most common type is a correspondence audit conducted entirely by mail. The taxpayer will receive a letter from the IRS informing them that they are being audited and asking for additional information or documentation. The taxpayer then can respond by mail with the requested information.

Office Audit

In-person or field audits are less common but can be more intense. The taxpayer will meet with an IRS agent at a time and place of the agency’s choosing. The meeting will usually occur at the taxpayer’s home or business. This can happen when complex issues are involved or the agency suspects fraud.

Line-by-Line Audit

The line-by-line audit is the most exact type of audit. The IRS agent will go through the taxpayer’s entire return line by line, looking for errors or discrepancies.

Signals That Could Trigger An Audit

The IRS can audit your business for several reasons, but there are a few red flags that could trigger an audit. For example, the IRS will pay close attention to see if you made any mistakes in reporting income or expenses or if you’re underreporting your income.

Another thing the IRS looks at is whether your business is organized as a sole proprietorship, partnership, LLC, or corporation. Each type of organization has different tax rules and regulations, so the IRS wants to make sure you’re following the correct procedures. If they see any discrepancies, they may flag your return for an audit.

Second, include all of the necessary documentation with your tax return. This includes things like forms and receipts for deductions. This may flag your return for an audit if you miss any documentation.

Finally, keep detailed records of your income and expenses if you’re self-employed. Auditors will often look closely at self-employed taxpayers, so it’s essential to have everything in order.

Account For All Of Your Income

This includes money from your job, side hustles, investments, and other sources. The IRS will want to see proof of income, so keep records of your earnings.

If you’re self-employed, you’ll need to account for your business expenses. This includes things like office supplies, travel expenses, and marketing costs. The IRS will want to see receipts or bank statements showing these expenses.

Keep in mind that the IRS may also ask for proof of charitable donations, medical expenses, and other deductions. So be sure to have documentation handy in case you are audited. The best way to avoid an audit is to be diligent in tracking your income and expenses.

Foreign Income

Omitting foreign income from your US tax return can result in significant penalties from the IRS. To avoid these penalties, make sure that you accurately report all of your income, regardless of where you earned it.

Stay Consistent With Your Accounting Methods

The IRS will most likely select your return for examination if you are audited because your tax reporting method did not match the industry norm. The agency will then ask you to explain the discrepancy. Therefore, it would be best if you were prepared to show documentation that supports your position.

Suppose you change your accounting method after being selected for audit. In that case, the IRS may disallow some or all of your deductions. So it’s vital to choose an accounting method that you can stick within the long run.

What Is The Statute Of Limitations For Tax Auditing?

The statute of limitations for tax auditing is generally three years from when you filed the return. But it can be extended to six years if you file a fraudulent return or do not report at least 25% of your income.