Being audited by the IRS can be one of the worst experiences of a lifetime, and the IRS has tremendous resources to use against taxpayers. In 2009, over 1.4 million individual income tax returns were selected for an IRS audit, which was roughly 1% of the total number filed.1
So What is an IRS Audit?
An IRS audit is a review or examination of your accounts and financial information to ensure that information is being correctly and accurately reported on your tax return(s). Most taxpayers understand IRS audits as a review of their individual income tax returns (Forms 1040), but IRS audits can include a review and examination of any number of filings, including Forms 1120, 1120S, 941, and more.
Types of IRS Audits
Because the trend to auditing returns has been steadily increasing over the years, and it is important to know the various types of IRS audits. This will allow you to be better prepared if you are selected for an IRS audit.
1. Field IRS Audits
A field audit is the traditional perception of the IRS’s audit techniques. IRS Revenue Agents from local offices conduct field audits, which are a more detailed review of your books and records. IRS field audits can take place at various locations, but IRS Revenue Agents generally try to hold them at your home or place of business. Because IRS field audits are more detailed, they can take months to complete.
In 2009, there were over 300,000 field audits of individual income tax returns in the United States. Those field audits resulted in the IRS recommending over $7.1 billion in additional tax, or roughly $21,000 of additional tax recommended per tax return audited. Only 11% of IRS field audits in 2009 resulted in a no change to the individual income tax return.2
2. Correspondence IRS Audits
A correspondence audit by the IRS is their most common tool to determine the validity of individual income tax returns. As the name implies, they are generally conducted through the mail with a Revenue Agent or Tax Compliance Officer at the IRS.
IRS correspondence audits are generally less intrusive than field IRS audits. They typically focus only on a few issues such as itemized deductions, Schedule C business expenses, or self-employment tax calculations.
In 2009, the IRS conducted just over 1 million correspondence audits of individual income tax returns. Of those selected for audit, 12% resulted in no change. However, the remaining correspondence audits resulted in a recommendation by the IRS of over $7.7 billion in additional taxes. That translates into roughly $7,000 of additional tax recommended per individual income tax return audited by the IRS via correspondence in 2009.3
Correspondence IRS audits are still subject to the procedural requirements of other audits, and it is important to take any correspondence from the IRS very seriously.
3. Office IRS Audits
Some IRS audits occur at a local office. They are usually somewhere between a correspondence and field audit as they relate to length and detail. Issues often considered are factual in nature such as dependents, head-of-household, and others.
The IRS uses a sophisticated program to score each tax return, giving each a Discriminant Function (“DIF”) Score. The DIF Score is a statistical tool the IRS has to determine which returns are more likely to result in additional tax assessed if audited.
Just like any other tool, the DIF Score system must be maintained from time to time. In order to calibrate the DIF Score, the IRS selects some tax returns for audits at random. Generally you will be told if your return was selected as part of the IRS’s National Research Program. Unlike other IRS audits, the scope of the research IRS audits is pre-determined and cannot be deviated from with ease. However, small adjustments may be waived for other reasons even though they are recorded for research purposes.
Not only does the IRS perform audits for civil tax enforcement, but it is a tool in criminal investigations.
What Can/Should I do During an IRS Audit?
If you find yourself in an IRS audit, here are some things you can and should do:
1. Be prepared
Organize, organize, organize! Being prepared for an IRS audit is one of the most critical components to a successful outcome. IRS audits generally commence two years after the original tax return is filed, so taxpayers should go back and review the return under audit. Prepare receipts, bank statements, invoices, and other supporting documentation in an organized format. Categorical (e.g., insurance, income, etc.) or chronological organization are often the most effective organization are often the most effective. Especially where substantiation is a key issue in the case, being prepared and organized will make the IRS audit progress quicker and minimize its expansion to additional issues and periods.
2. Keep complete records of documents received and submitted to the IRS
The documents the IRS sends you are often time-sensitive and can trigger very important legal rights. Similarly, it may be necessary for you to prove what you did or didn’t send to the IRS along the way. When the IRS sends you documents, keep them in a folder in chronological order. Likewise, when you send something to the IRS keep a folder with copies. When submitting documents, itemize them in a transmittal letter. For example, include a cover letter in your response to the IRS that says “Enclosed for your reference are: (1) my bank account statements from account xxxx-xxx from January 1, 2010 through December 31, 2010; (2) a copy of my auto insurance policy dated July 12, 2010 …”
3. Get contact information for the IRS examining agent (“Revenue Agent”) and their Group Manager
Taxpayers need to know who they are working with and how to get a hold of them. Depending on the type and scope of the IRS audit, a taxpayer may have to mail fax, or even email documents to the IRS agent. Having that information readily available will help keep your audit on track. Most professional auditors will proffer their manager’s contact information at the beginning of the IRS audit. If not, taxpayers should gather that information. If there is a disagreement with the agent the Group Manager is usually the first step in vetting any issues. Obtaining their name, badge or employee number, telephone and fax number and address is important.
4. Be cooperative and forthright
Although an IRS audit can be an adversarial process it pays to be cooperative and polite. You should also expect the same in return. Getting along with the an IRS auditor can be an important key in conveying your positions. Being critical, condemning the IRS auditor’s conduct or not showing respect for the IRS auditor can cause irreparable damage to your case. Moreover, being forthright is critically important to avoiding expansion to other issues. If the IRS auditor believes you are being evasive, you could end up with additional years and issues under audit, or worse, under fraud or criminal investigation.
5. Establish a dialogue on expectations and ground rules
An IRS audit is a back-and-forth process, and you should seek to set up some understanding on how the game is going to be played. Discussing with the auditor when you will be expected to reply to any Information Document Requests (IDRs), the estimated completion date (‘ECD’) of the audit, and the time and place of the examination is important. It is usually best to establish your window of response as late as possible. By waiting until later in the window to respond, but responding timely, you can give yourself even more time to adequately prepare. Remember: organize, organize, organize! Another expectation you do want to establish is when and where the IRS audit will take place. You don’t want the IRS to come to your home or business, but if it is unavoidable, ground rules need to be discussed with the auditor. The visit should be brief and timed when it is least intrusive and disruptive.
6. Anticipate the auditor’s plan if you can
Knowing where things are heading is the first step in avoiding problem areas. Professionals who have done many IRS audits may be able to better anticipate problem issues and the auditor’s plan, but do anticipate to the extent you can, it will only help you dispose of issues and limit the scope of the IRS audit.
7. Get copies of IRS documents
The IRS will be compiling an administrative file during the course of your IRS audit. You should request copies of various items along the way. Some of the more important items to get copies of are signed statute extensions, work papers showing how the IRS made its calculations, and a list of any third-party contacts. If you provide a statute extension (Form 872), ask the auditor for a copy. The IRS generally has only a limited number of years to propose any audit adjustments unless you extend that statute. Knowing if or when the statute was extended could be an important issue later on. If the IRS auditor is proposing an adjustment ask for all the work papers to support the adjustment. This is very typical if unreported income is an issue because the IRS will prepare detailed worksheets for a bank deposit analysis. You also have a legal right to information about any third-party contact so do not be afraid to ask for it.
What Should I Not Do in an IRS Audit?
1. Lie or submit false documents
Never lie or submit false documents during an IRS audit. Lying or providing false documents to an IRS auditor can be devastating and possibly constitute criminal conduct. An IRS agent is not necessarily hunting for fraud and criminal conduct, but lying or submitting false documents will invariably lead to a fraud referral. Even if the IRS chooses not to pursue a criminal case, such conduct could lead to a civil fraud penalty or other stigma that cannot easily be shaken.
2. Be brash, unprofessional, or uncooperative
The IRS is comprise of competent professionals. Although an IRS audit is an adversarial process, professional courtesy should not be abandoned. After all, it is a people management game at some level.
3. Do the government’s work for them
The IRS has the burden on many items and needs to conduct the audit. You prepared the tax return and filed it, and yes, you are responsible for substantiating may of the items on the return. But the IRS is responsible for additional items and you should not have to do their job.
4. Make idle remarks
Volunteering information or answering questions not asked can lead to big problems. Off-handed remarks that are not in response to a direct question, and which have not been thoroughly though through frequently expand an IRS audit and lead to further adjustments. The auditor learns something every time you open your mouth. Comments, no matter how benign you might think they are, can prompt the IRS to look into new issues they did not previously consider. If asked, answer truthfully, but briefly. But don’t make casual comments regarding your returns or your financial dealings.
5. Miss the opportunity to know what the IRS is doing, should be doing, and why.
You are not a pushover and you should not feel powerless against in an IRS audit. You have the right and should exercise it, to understand what, if, and why the IRS is doing something. If you don’t understand what is going on or where the auditor is finding support for their determination, ask. This will provide you with an insight to have a discussion as to whether they were right.
6. Give the IRS original documents
Never give the IRS original documents in an IRS audit! The IRS will request information and documents from you. It is perfectly acceptable to make copies of documents and provide them in lieu of originals. Once original documents are turned over to the IRS, it can be difficult or impossible to get them back. If needed for future use, you could find yourself in a precarious position if you no longer have possession of original documents needed to prove your case.
Why McLaughlin Legal?
This information about IRS audits may be helpful to some. However this is for general information purposes only and should not be considered the rendering of legal advice. You should contact a tax professional if you have a question about an IRS audit, or if you are the subject of an IRS audit.
McLaughlin Legal would be happy to be that resource for you. McLaughlin Legal is a boutique San Diego law firm specializing in defending taxpayers and resolving tax disputes. We have represented numerous individuals and businesses before the IRS and have the experience and skill to assist you.