The IRS is often portrayed as a scary group of calculator-wielding mercenaries who are just out to get more money out of you, but in truth you only have something to fear if you’ve intentionally falsified your taxes or are guilty of tax evasion fraud.
Nevertheless, you may still be audited during your lifetime, either as part of a randomly selected group, or because you have certain red flags in your return. The IRS generally has up to three years after you file or the due date (whichever is later) to audit your return, but it can audit up to six years in some cases. If you file a fraudulent return or don’t file at all, there is no statute of limitations on when the IRS can audit you.
If this ever happens to you, here are a few things you should know about IRS tax audits.
4 Types of Tax Audits
1. Correspondence Audit
This is the most common type of audit and is simply a letter from the IRS, asking you to provide documentation for tax deductions and credits, or asking for other records. Sometimes you may get a letter stating that you have accrued some kind of penalty, such as a late filing penalty, but you can write back to them with evidence disproving the penalty, if you have any such evidence.
This sometimes happens when the IRS’ records don’t match up – for example, if you reported a charitable deduction, but the IRS didn’t receive a matching report of that donation from the charity. These are usually easily solved, and if they determine you to owe a penalty or additional taxes, you can either choose to pay it or appeal it further and move on to the next step of the audit process. Keep in mind that if you don’t think you have a good chance of proving your case, and especially if the amount is small, you’re frequently better off simply paying it because the interest and penalties can far outgrow the original amount of extra tax they say you owe. If you don’t prove your case, and you end up being on the hook for the disputed amount, you’ll have racked up a lot of interest in the time elapsed.
2. Office Audit
This type of audit involves a letter from the IRS asking you to compile documents from a list they provide you, and then report to your local IRS office to go over them with an IRS agent. Frequently these types of audits are used for small businesses, such as those operated from your home, since it’s not really necessary for an auditor to come to you.
Small businesses are more frequently audited than individuals, since it’s a popular way for the unscrupulous to write off unnecessary purchases and/or employ relatives who don’t actually work. Keep in mind that it is very easy for the IRS to access your bank records, so if you’ve “accidentally” not recorded some profits, now is the time to fess up and avoid a criminal investigation. However, if you have been completely on the level, don’t give them any more information than they specifically ask for, lest you open a can of worms!
3. Field Audit
This type involves an IRS agent, or sometimes multiple agents, actually coming to your home or business to inspect your books and facility, and better understand how the business works. This is less common for individuals, but much more common for larger businesses. The IRS will call you ahead of time to set up a date for the audit, talk to all the owners of the business, and give you a list of records they’ll want to look at.
This gives you an opportunity to get things organized before they show up. In the movies, they arrive out of nowhere, but in real life, nobody’s files are organized enough for a drop-in visit! If you don’t have a CPA or financial advisor, you’re going to want to get one now, since they’re likely to ask you a lot of complicated questions you won’t be able to answer. If the IRS agents have to figure it out themselves, you’re not going to come out on the good side.
In a field audit, you also have more opportunities for the field agents to stumble on things that they hadn’t specifically asked for – such as going into your personal taxes – so it’s important to have your CPA on hand for the actual audit to make sure the agents are only viewing those records and tax statements that are part of what the IRS had originally asked for.
4. TCMP Audit
The TCMP, or Taxpayer Compliance Measurement Program, is the least common type of audit. This is an audit that occurs completely randomly, and without any evidence that you have done anything wrong, but simply as a sort of spot-checking that the IRS does on randomly selected tax returns every year. You’ll need to provide documentation for every single dollar of income and every deduction or credit, as opposed to in other audits where they’re looking at something specific. But relax – the agents have dealt with worse than your return, so they’re not going to tack on egregious fees unless they actually find something.
Tax Audit Help & Tips
If the IRS determines that you made a mistake, you’ll owe – but if you find out there were deductions or credits you’re entitled to, the IRS will cut you a check for what they owe you! So you’ll want to work alongside the agent and keep your eyes open for any mistakes you might have made in that direction as well.
Keep all your paperwork each year in a carefully labeled folder, and if possible in a fireproof safe, or keep copies somewhere other than your home. “The house fire ate my tax deductions” is not a good excuse for the IRS on audit day.
6 Common Audit Red Flags and Issues
1. Employees vs. Independent Contractors
If you have your own business and employ anyone else, the IRS will definitely want to examine whether they were classified appropriately. It’s very important to make sure that anyone who meets the definition of an employee gets treated as one – otherwise you could owe not only the amount you should have paid towards that person’s taxes, plus penalties and interest, but also up to 35% of the TOTAL amount you paid them!
2. Income Reported to the IRS that Isn’t on Your Return
Every time you get a 1099 or a W-2, the IRS gets one too. And guess what? They’re going to expect to see that on your return. So if there was income reported that you didn’t include on your return, that will be picked up by the IRS computers (granted, it may take a year or two for you to hear about) and your tax return will be re-run. You’ll end up paying the taxes on that income anyway, plus fees and interest.
3. Large Business Losses
Starting up a business is an expensive endeavour, and many startups fail, but the IRS doesn’t cast a friendly eye on a business that loses thousands of dollars in a single year. Businesses that don’t make money for three years are reclassified as “hobbies”, for which the amount you can deduct is limited. Make sure you keep every receipt and keep your books squeaky clean if you expect to run at a loss – and make sure any physical equipment purchased for the business is still in use, and not being used in your daughter’s Miami apartment. Losses on rental properties are also a big red flag, since presumably they are intended to be a real estate investment which generates income, not a money hole that generates small business tax deductions.
4. Very Large Charitable Donations Relative to Income
While donating to charity is a great way to reduce your taxes, sometimes unscrupulous types use it to move undocumented income and get a tax break. If your charitable donations are more than 10% of your income, you’ll want to keep your receipts and check out your charities carefully.
5. Home Office Deduction
Just by itself, the home office tax deduction isn’t a huge money-saver because it can only be used if the business made a profit. But if you’re claiming an unreasonably large or expensive office, or are trying to deduct fancy equipment or unnecessary repairs, you might get a call from the IRS. Your home office has to be a home office 24 hours a day, and you can’t take the deduction if you are an employee that works at home but your employer still keeps an office for you at work.
6. A Big Mouth
Yep, your loving relatives and doting coworkers can get a big fat payment for ratting you out about how you pulled one over on the IRS, and they just might. They can get a bounty of up to 20% of the taxes and penalties that the IRS recovers from you – and a major source of tips come from jilted lovers and ex-employees. Considering that the IRS can audit several years back on your taxes, it’s wise to keep from bragging.
Being audited can be a big pain, but if you have kept diligent records and been honest with the IRS, then you have nothing to worry about. Just cooperate, be prepared with your documentation and everything will turn out fine.
Have you ever had to go through a tax audit by the IRS? Share your experiences here.