There are almost as many stories about tax audits as there are taxpayers. Recently my office received an email from a woman who is still trying to get out from a criminal tax issue spanning back ten years.
She wrote “Today I got a letter in the mail. The tax issue is in California and I am in Hawaii. This is my first letter and I’m freaking out. I’m going through a separation right now. I was trying to start a business here in Hawaii and then COVID-19 hit. Now I get this letter from the IRS.
I’m in over my head – a single mom, distant learning, divorcing, and at this point if I got hospitalized with COVID-19, I might consider it a relaxing vacation. Anyway, I don’t know if you can help me, but maybe you could refer me to someone who can?”
It Starts With A Letter
Generally, the IRS audit process starts with an informational document request, which will include items like bank statements, invoices and receipts. The auditor requests information surrounding their examination of whatever tax return is under audit.
Usually, IRS audits go back three years. The taxpayer will then gather that information and will meet with the auditor to review it.
Many times, by looking at the auditor’s document request, we can tell why the return got audited. Most audits will focus either on the income side of things or on the deduction side of things. Occasionally, they will focus on both.
It is important that you cooperate with the auditor regarding requests for information. This is not the time to challenge them. If you have established a congenial relationship with the auditor, you might be able to persuade them to back down in certain areas; maybe to a shorter time frame or maybe they will overlook that you are missing some receipts.
But, do not press your luck. If you refuse to provide the auditor with the documentation they request, they can always get a summons, then you will wind up in district court. You definitely do not want to be there. The IRS can also issue a summons to get information from a third-party, such as your bank.
The taxpayer or their representative will meet with the auditor and the auditor will go through the substantiation with the taxpayer and/or their representative. At the end of the review, the auditor will make adjustments based on what they feel is owed to the government. This will be presented to the taxpayer as an audit report.
The duration of the audit will depend on what the IRS is looking for. Typically, it should take only one or two meetings. However, if the auditor has to spend a lot of time tracking down documentation, it could take much, much longer.
If your audit drags on for many months or you are having multiple meetings with the auditor, then something is seriously wrong.
That is why it is important that you control the audit, not the other way around. Keep the auditor focused on the main objective and have all of your information available and in a format that makes the auditor’s job easy.
If the taxpayer agrees with the audit report, then the audit is over. If the taxpayer or the representative disagrees with the report, they may submit additional documentation or work to clarify things in the audit report.
If the auditor and the taxpayer ultimately cannot agree, then the case goes to appeals where the taxpayer can further challenge the audit.
A quick tip is that if you want to score major points with the auditor, be organized. We always advise our clients to keep all of their documentation as clean and tight as possible. Do not show up with haphazardly-packed boxes that the auditor has to spend time digging through. If you can put all of your materials in a binder with tabs, all the better.
I always tell clients that their tax return is their abridged autobiography. Well, here is the full story. If you can keep things as straightforward as possible for the auditor, the more likely the chips will fall in your favor.
What Constitutes Taxable Income?
The IRS audit is going to hone in on whether or not you correctly reported your taxable income. Simply stated, taxable income is the combination of income and expenses that determines the amount of taxes you pay.
Essentially, what the IRS is doing is coming in and just verifying that the information is correct. Like I have mentioned, your tax return tells a story. When IRS auditors read it, they pay strict attention because it contains a treasure trove of information about you.
It tells whether or not you are married, it tells whether or not you have kids, it tells where you live, it tells where you earn income from, and to some limited degree, what you spend money on.
That is what the government is interested in. When the IRS comes in and audits you, chances are they are auditing you because that story does not match or something does not make sense based on what you are telling the government.
Something Does Not Look Right Here
When that story does not match up or when there are additional questions that may yield a result that is favorable to the IRS, they will probably want to audit the return.
For example, a number of the things that we consider traditional audit red flags are round numbers or increased travel expenses or meals and entertainment deductions. Those items are more likely than not to get picked up by the IRS in an audit.
For example, a taxpayer may have earned a certain level of income over two years and then has a significant reduction in income in the third year. The IRS may want to know why.
Essentially, the auditor is going through and looking for errors and adjustments that they can make in order to give additional tax to the government. If those errors start to add up or the taxpayer is unable to substantiate the deductions and the income that they took on the return, then the IRS auditor will issue penalties in connection with that.
Another example would be if you earn $30,000 a year and live in Beverly Hills, or perhaps you are a multi-millionaire and live in a low-income neighborhood. That does not make sense and the IRS would want to know why.
There is not much that you can do to reduce your audit risk because the formula for calculating who gets audited and who does not is not common knowledge, but generally speaking, when the IRS chooses to audit the return it means that they are looking to get something back.
If the auditor finds mistakes or if they do not believe that your documentation is properly substantiated on the return, then not only will they assess your tax but they will hit you with additional penalties and interest. In addition, the auditor is often engaged in what we call a fishing expedition, which is when they start examining the return line-by-line in terms of looking for more and more errors.
An auditor who finds errors on a return is more likely to dig and dig and dig and dig until they are satisfied that they found all the errors that could possibly exist on the return.
So, keep that in mind if you are selected for audit, you may not know the reason why. You may not know why your story is out of sync with the government, but you can at least be reassured that the IRS is not going to undergo an audit unless it has the expectation that you are going to pay more in taxes.
Do Not Be Paranoid
I would like to believe that most auditors go into the process with good faith. My experience has been more positive than not in this arena. The IRS is like any other organization. There are good people within that organization and there are bad people within that organization.
Ultimately, the auditor's going to do their job. Good or bad, they are going to go through the audit, they are going to find the mistakes, and they are going to assess how much tax they think is due.
The best thing that you can do to mitigate this is plan to make your presentation as mistake-free as possible. This way, you can get through the audit with your dignity intact.
If you are scheduled for an audit with the IRS and would like some assistance with your presentation, I can help. If you perceive that the penalties charged for line item problems within your return are exorbitant and are choosing to take your case through appeals, I can help, too.
I will take a look at your tax story and give you my professional advice. If you work with me and my staff at Brotman Law, we will strive to give your story a happy ending. In any case, it will likely conclude with a moral lesson about how to avoid having the IRS come knocking on your door in the future.