Are you at risk for an IRS Audit?
There are generally four overarching audit triggers that lead to an IRS audit. Each major trigger will result in a different type of audit. As a taxpayer, you should understand what the IRS is looking for, which will help you stay in compliance and significantly mitigate the chance of an IRS audit.
- Failing to File a Tax Return for Multiple Years
- Leaving Certain Income Off your Return
- Large, Unusual, and Questionable Items on your Return
- National Research Program Audits
Missing Tax Returns
Everyone is familiar with the annual “tax” forms they received during January and February (W2, 1099MISC, 1098, etc.). However, these forms are not just used so you can prepare your tax return. The IRS receives a copy of all of these forms and creates a detailed database for each taxpayer. This allows them to see who should be filing a return.
If you fail to file a tax return and have a W2, 1099-Misc, 1098 on file with the IRS, more than likely, the IRS will initiate a type of audit under IRC § 6020(b). In most cases, the IRS will prepare a return with the information on file, which is referred to as a Substitute for Return (SFR). Overwhelmingly, these returns result in disproportionately high tax liabilities because the IRS does not account for any deductions, special tax treatments, etc.
Alternatively, the IRS may decide to conduct a full blown audit, particularly if you are operating a sole proprietorship or are otherwise self-employed. This means the IRS will take an in-depth look at all of your records (bank statements, receipts, etc.). If your records are incomplete or you are not sure how to prepare them for the audit interview, you may end up with a significant tax bill. The good news is you can mitigate this risk by filing your returns on time (even if you know you are going to owe and cannot pay).
This type of audit is referred to as an Automated Underreporter Audit (AUR). The process in which you could be selected for an AUR is similar to missing tax returns. The IRS compiles information returns (W2, 1099-Misc, 1098, etc.) and matches them to what is reported on your return. If something does not match up with the IRS records you may receive a notice requesting an explanation. It is extremely important to respond to the notice because if left alone the IRS will assess a deficiency and apply a 20% accuracy related penalty.
Here is a list of common items left off of a tax return and brief look at why you should report them correctly:
- 1099-R (IRA or 401k distribution).
- If left to the IRS you could be assessed an additional 10% penalty for early withdrawal, even if you had a qualifying reason for taking the money out.
- You may not get credit for basis in the retirement account.
- 1099-Misc (generally from self-employment income).
- If income is shown in box 7 for non-employee compensation the IRS will treat this income as self-employment income. Self-employment income is subject to Federal Income Tax and 15.3% employment taxes.
- If the income is from self-employment, the IRS will not automatically give you credit for expenses (mileage, insurance, rent, etc.).
- 1099-B (From the sale of stocks).
- Generally, the IRS will not receive information about your basis in the stock. Therefore, if you do not respond, the IRS will tax you on the entire gross proceeds instead of the gain. You may also lose preferential capital gain tax treatment because the IRS may not know if it is a long-term or short-term capital gain.
Large, Unusual, Questionable (LUQ)…
Another common audit trigger has to do with what is reported on your tax return. At various times, the IRS will task several Revenue Agents to hand review a large quantity of tax returns. The Revenue Agents are looking for LUQs.
- LUQ Breakdown
- Large: Comparatively large expense on a schedule C (i.e. realtor shows $40,000 in Schedule C expenses and $30,000 comes from repairs). Also, a large donation that exceeds or nearly eliminates the taxpayer’s income from other sources.
- Unusual: The IRS will look at the character of the expense (airplane expenses for a plumber, etc.).
- Questionable: Using round numbers on each expense line of a Schedule C.
Naturally, you may have tax years that legitimately include LUQs as defined above. If that is the case, you should make sure to keep adequate records to defend against the higher chance of an audit.
National Research Program Audits (NPR)
More commonly referred to as the “audit from hell” these audits are not triggered at all. Instead, the IRS uses a completely random selection process. Ultimately, if you are unfortunate enough to get selected for an NPR audit you will face a grueling line-by-line audit of your tax return (and finances). The IRS uses the information gathered from these audits to allocate its resources and update trends for taxpayer non-compliance. Therefore, it is necessary for the IRS to apply strict guidelines when conducting these audits (otherwise the statistics they are generating would be unreliable). Generally, the average taxpayer will end-up with a tax bill at the end, unless all the income and deductions reported can be substantiated / recreated. The key to getting through this type of audit is preparation and knowledge of the tax laws.
What you need to know about the Audit Process.
The general process of an audit depends on the type and location of the audit. Audits can be broken down into three major categories.
- Correspondence Audit
- The IRS requests substantiating documents through the mail.
- These can be difficult because you usually do not get to speak with an auditor, which often times results in having additional taxes assessed.
- The goal is to send in credible documents that address/prove every element of the specific Internal Revenue Code (IRC) section.
- In-Office Appointment
- These audits require you to schedule an appointment at your local IRS office with a Tax Compliance Officer (TCO) or Revenue Agent (RA).
- At the appointment, the auditor (TCO or RA) will ask a series of questions to determine if additional years or items on your return should be opened.
- You should respond to the notice because if not the auditor may decide to open other years and items. Then he or she will disallow all the deductions (because you did not show up) and assess a substantial tax deficiency.
- Field Audit
- With IRS budget constraints these audits have become less common.
- They are generally limited to businesses.
- The auditor will schedule a time to come out to your business location and review finances. This can cause an interruption in business operations.
The process of each audit follows the same general path. First, you are given notice of the audit with a request for information. The information request will let you know what areas and years have initially been selected for review. However, these are not set in stone.
Initially, your 2015 and 2016 Schedule C is selected for audit. You show up to the audit and the auditor determines during the interview that you may not be eligible for charitable contributions on your Schedule A. The auditor then opens that area of the return and schedules a follow-up appointment.
Luckily, with proper planning, you can avoid this situation. Hiring an attorney to show up to the audit for you is often a great solution. Generally, the auditor will ask fewer questions and/or the attorney can limit the scope of the audit. Not to mention, you will not have to sit across from the auditor and instead can go to work or otherwise keep your regular schedule.
After the initial interview is completed, the auditor will issue a Form 4549 Income Tax Examinations Changes. This form will show the recommended changes from the audit. The 4549 will also be accompanied by an 886-A, which will explain why an expense was allowed or disallowed. From here, you have several options. If you disagree with the audit findings you can call the auditor and try to argue your case. If that does not work, see below (What to do if you missed the audit or disagree with the outcome).
What to do if you Missed the Audit or Disagree with Outcome
Whether you missed the initial audit deadline or disagree with the audit findings you still have options. In fact, there are several administrative and procedural steps that remain available after an audit has completed. Here we will cover the three most common options available.
- Appeal your case
- Petition the United States Tax Court
- Submit an Audit Reconsideration Packet
After the audit is complete you will receive a 30-day letter with appeal rights. This letter gives you 30 days to submit an appeal for consideration by the IRS Office of Appeals. During the appeal, you will be given the opportunity to present any contested areas for independent review by an IRS Appeals Officer. If you missed the original audit you may need to file an appeal to preserve your rights (you should seek legal advice on this matter).
If you fail to appeal within the 30 days or you lose your case at appeals you will receive a Statutory Notice of Deficiency. This is a legally significant document because it gives you 90 days (150 days if you are out of the country) to petition the United States Tax Court. If you miss the deadline you will lose your right to seek review from the Tax Court. Nevertheless, you still have another readily available option.
If you miss the deadline to petition the Tax Court you can still submit an Audit Reconsideration packet. This procedure is strictly administration and at the discretion of the IRS. In other words, you do not have a statutory right to audit reconsideration. However, if you are presenting new information not already considered the IRS will generally accept the packet for review. This is a very powerful tool, especially if you missed the initial audit or tracked down additional substantiating documents.
How many Years can the IRS Audit?
Under the right circumstances, the IRS can audit and assess additional taxes for every year you file a tax return. However, this is typically restricted to cases where there is fraud on the part of the taxpayer. For most cases, the IRS can only assess additional taxes for 3 years. Nevertheless, there are several factors that can extend the statute of limitations on assessments.
- The IRS is generally limited to three years to assess additional taxes.
- This limit is extended to six years if you omit 25% or more from gross income (see more at IRC § 6501(e)).
- The limit becomes indefinite if you file a fraudulent return or fail to file a return at all.
Whether or not the IRS can audit/assess additional taxes for more than three years is a fact specific inquiry. If you feel the IRS has exceeded its authority you should seek immediate advice from a tax attorney. For more detailed information about the application of these rules please read our article Can the IRS audit every year?
Powerful Tools that could Save you Thousands.
When dealing with the IRS or other taxing authority it is important to arm yourself with as many tools as possible. After all, leverage and preparation are vital to tax negotiations. There are two commonly overlooked strategies that strengthen your negotiating position with the IRS. For preparation, submitting a “qualified amended return” could save you thousands. For leverage, proposing a “qualified offer” will apply significant pressure to the IRS.
What is a Qualified Amended Return?
In a nutshell, a qualified amended return is one that is submitted before you are notified of an audit for a particular year.
You are notified that your 2015 tax return has been selected for audit.
You identify a mistake made on your 2014, 2015, and 2016 returns and believe the IRS is going to open 2014 and 2016 after the interview for 2015.
If you file an amended return correcting the mistake BEFORE a notice is received opening 2014 and 2016 for audit it will save you significant penalties. At a minimum, you should be able to avoid the 20% accuracy related penalty.
Whether or not you should file a qualified amended return is fact specific. You should speak with an experienced tax attorney to develop a strategy that is right for you.
What is a Qualified Offer?
A qualified offer typically occurs after you petition the United States Tax Court (but before the trial). Essentially, you offer an amount to the IRS that you believe will be proven during court. This puts pressure on the IRS for one major reason. If the final decision at court results in a liability for less than the offered amount you can get the IRS to pay for your representation. As you can see, the IRS must take these offers seriously because they do not want to lose the case and foot the bill for your attorney.