What is it about the words “tax audit” that so many people find so anxiety-provoking? The idea that the Internal Revenue Service (IRS) could be poring over your tax return can be downright nerve-racking, not to mention the possibility of mistakes found and penalties incurred.
But take a deep, calming breath: In the last decade to be reviewed, the IRS audit rate has been declining, going from 0.9% in 2010 to 0.25% in 2019. But even so, you likely want to do your best to avoid going through that process.
This is an informative, high-level overview of IRS audit triggers, and it should not be considered tax advice. It’s always worth consulting a tax professional for any questions or concerns because taxes are complicated and highly personal.
Read on to learn:
• What is an audit?
• What are reasons why someone may get audited?
• What should you do if you get audited by the IRS?
What Is a Tax Audit?
A tax audit is a process by which the IRS reviews an individual’s or organization’s accounts as well as their financial details to make sure that the information submitted has been reported correctly and in keeping with the prevailing tax laws.
The IRS usually sends a letter when it reaches out to ask for more information, and the letter should let you know specifically what the agency is looking for.
You shouldn’t ever receive a text, email, or phone call from the IRS asking for personal or financial information. If you do, the IRS website offers several steps for checking out and reporting any suspicious contact.
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Reasons Why Someone May Get Audited by the IRS
Here’s a closer look at some of the typical IRS audit triggers. Knowing them can help you understand and possibly avoid the process as you work your way through tax season.
• You’re a high earner. Those who earn between $200,000 and $1 million were audited at a rate of less than 1% in a recently reviewed year. However, those who earn over the $1 million mark were audited at a 2.5% rate, a big jump up. If you are a high earner, it may be worthwhile to work with an experienced CPA to ensure you file precisely. You may also want to investigate ways to lower taxable income for high earners.
• You claimed the Earned Income Tax Credit. The Earned Income Tax Credit, or EITC, is a provision that helps lower- and moderate-income workers and their families receive a tax credit. This can reduce the taxes owed or possibly increase a refund. However, research indicates that those who claim the credit are audited at a higher rate than average, perhaps because the IRS wants to be sure the credit is being used appropriately.
• You failed to report all your income. When you are issued a W-2 form or 1099 form showing your earnings, the IRS receives a copy too. If your return doesn’t reflect the same figures that they have when they perform a cross-check, you could wind up being audited.
• You didn’t report all of your stock trades. When you sell stock shares, the funds you receive are taxable unless the investments happen to be a retirement account that is tax-deferred. Both you and the IRS will be sent a particular kind of 1099, a Form 1099-B, reflecting activity, and you will have to report your capital gains and losses when you do your tax return. The tax rate will depend on how long you have held the investment, but it’s important that these transactions be reported and paid up when you file your return.
• You claim large charitable contributions. If you claim tax deductions for charitable donations of cash or items, it’s important to keep records at the time you file. It’s your responsibility to have the documentation of what you have given if it’s in the amount of $250 or more. Large and unsubstantiated contributions can be problematic.
• You claim a home office. If you are self-employed, you may deduct a percent of your rent, phone bills, and other work-related costs on Schedule C of your return. Another option is to deduct $5 per square foot of space used for business, up to $1,500. However, the IRS has over the years been successful in minimizing this home office deduction on returns, especially since the home office must be for the exclusive purpose of work; it can’t double as, say, a guest room. This means it can be an audit risk to take this on your return.
• You claim that your car is only used for business. This is another audit red flag. If you are self-employed and depreciate a car on Form 4562 and claim that it’s used for business 100% of the time, you may well be stretching the boundaries of believability. Because it’s unusual that a vehicle wouldn’t also be used for personal transportation, you may trigger an audit with this 100% figure. It can be important that tax deductions for freelancers aren’t too large versus income.
• You accept cash transactions. If you work in the kind of business where you get paid in cash, especially large amounts, your return may receive extra scrutiny. The IRS is notified of cash transactions over the sum of $10,000 involving banks, car dealerships, casinos, and other businesses. Banks must also report potentially suspicious transactions involving cash (for instance, if someone deposits $9,500 in cash one day and $700 the next, thereby skirting the $10,000 reporting threshold).
• Your business regularly shows losses. Of course, not all businesses are always profitable. But if you’ve started an enterprise and it keeps showing losses, year after year, it might be what triggers an IRS audit. It could look as if you have established this endeavor simply as a way to benefit from some tax deductions. The same can hold true if your business is barely break-even.
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• You claim lots of travel and entertainment deductions. What else can trigger a tax audit? Here’s another one for self-employed workers: If you claim a lot of restaurant dinners, travel, and shows as business expenses, you may raise eyebrows at the IRS. This is especially true if the meals and hotels seem more lavish than your business might otherwise qualify for. Save all your receipts and documentation, and know that a high level of these expenses being claimed on Schedule C may get some attention and even an audit.
• You make errors on your tax return. As you prepare for tax season, you may feel overwhelmed or be in a rush. Or perhaps you’re just not the most detail-oriented person on the planet. But if you make math mistakes on your return or, say, round up numbers to the nearest $10 or $100 because you can’t be bothered with change, heads-up: You may put yourself in line for an audit. Precision and specificity do count.
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A Few Facts About Tax Audits
Here are a few points to be aware of on the topic of IRS tax audits. They may clarify some concerns that are on your mind.
A Compliance Contact Isn’t Always an Audit
A compliance check is a review done by the IRS to ensure that a taxpayer is adhering to the requirements for recordkeeping and information reporting. It does not relate directly to whether or not a person owes taxes.
There Are Different Types of Audits
Just as there are different kinds of taxes, so too are there different kinds of audits. If you are being audited by the IRS, there are a couple of ways this may happen. Mail audits are fairly common; in these, you mail in documents in response to specific inquiries. Office and field audits are more serious, and the IRS asks for proof of credits and deductions, and may look at your financial records more carefully to see if your tax return is correct. The IRS may be looking for tax evasion on these kinds of audits. The third kind of audit is what’s known as a CP2000 notice. Technically, this isn’t an audit but an underreporter inquiry, and is likely about a discrepancy between your return and the tax documents that were filed with them for the tax year in question.
Some Groups Face Higher Audit Rates than Others
While audit rates have dropped for all income levels, those with incomes below $25,000 and above $500,000 are audited at higher rates than the average.
Good Record Keeping May Offer Protection
If you are audited, it can be very helpful if your records are in good order. That way you can explain the amounts you reported and easily answer questions the IRS may have. This can serve as a good incentive for you to keep your records diligently going forward.
Ignoring the IRS Could Be Costly
What happens when you get audited can of course vary. But one possibility if you are audited is that you may be liable for back taxes not paid and penalties. These penalties typically accrue over time, so the longer you go without paying them, the higher they can be. That’s why it’s a good reason to respond promptly if you do get audited.
What to Do if You Get Audited
What if you are one of those few people who is told that your returns are being reviewed? This is what to expect and what to do if you get audited by the IRS:
• Typically, you will get a letter from the IRS in the mail that will identify an issue (such as your reporting less income than their records show you earned) and requesting a response.
• It’s wise to gather your documents so you can make your case. It can be smart to send your reply as a clear, concise statement of what your documentation shows and share those records to help prove your point.
• One important thing to do when you get audited is to reply in a timely manner and make sure your reply gets where it’s going. It can be a wise move to use additional mail services to ensure you have proof of delivery.
• If you worked with a CPA or an enrolled agent on your return, they can likely advise you. If you used tax-return software, they may also offer help.
• Your response to the mail inquiry may be enough to resolve the situation. Or the IRS may have additional questions for or requirements of documentation for you. If things escalate to a face-to-face meeting, you may want to have a tax professional work with you and accompany you for guidance and support.
• Whether it’s a correspondence exam or an in-person audit, you’ll get a printed list of specific records the IRS wants to see. If your audit is being managed by mail, you may be able to send the documents electronically or by mail. (Be sure to get a receipt for delivery.) Note the IRS will generally accept copies and they caution against mailing original documents in. If it isn’t possible to send the documents, you can request an in-person meeting.
• If you need more time to respond to a correspondence exam, you can fax or email a request for an extension using the contact information in your IRS letter. Or, if you’re being asked to comply with an in-person exam, you can contact the auditor assigned to your case to request an extension.
• Also worth noting: If the IRS finds discrepancies in your return, it may review returns from up to the last six years to better assess what the situation is.
No one can guarantee a return won’t be audited by the IRS — even if you aren’t doing any of the things most experts say might put you at higher risk. But if you’re honest about your income and your deductions, keep organized and complete records, take care to enter all information accurately, and double-check your work, you may be able to avoid major problems should you get audited.
Are audits always negative?
While IRS audits make most people sweaty-palmed, they can be as simple as answering some questions by mail. They are not necessarily as scary as you may think.
How do I know that I am being audited?
If you are being audited, you will be notified, most likely by mail, by the IRS.
What happens after an audit is conducted?
After an audit is conducted, you will be told the outcome. You may be told you owe taxes and penalties or not. If you are assessed additional taxes and fees, you can complete paperwork and pay them if you agree with the findings. If you don’t, you can contact the auditor to discuss and request a review of the findings. If necessary, the matter can be escalated to Alternative Dispute Resolution (ADR) or you can file an appeal with the IRS Appeals Office.
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