Fear of being audited by the Internal Revenue Service (IRS) can leave even an honest taxpayer unnerved. It’s important to be truthful when filing your taxes, of course, but it’s even more critical to be prepared to substantiate your return with complete records if and when the IRS comes knocking.
What Is an IRS Audit?
An IRS audit is generally an impartial review of your tax return to determine its accuracy. It is not an accusation of wrongdoing. But it is important to know that you, the taxpayer, generally have to substantiate the entries on your return. The IRS does not necessarily have to disprove anything.
For example, if you gave $100 worth of old clothing to a charity but did not receive a receipt or have other proof that such a gift was made, you could be in trouble if you’re audited. If the IRS questions the deduction and you cannot provide proper evidence that a gift, in such amount, was made, the deduction may be disallowed.
However, generally for certain taxpayers (e.g., individuals) whose audit began after July 22, 1998, the burden of proof changes. The IRS will have the burden of proof if these taxpayers have credible evidence relating to most factual issues, have complied with all requirements, maintained required records, and have cooperated with all reasonable IRS requests for information. Keep in mind, that the burden of proof does not change on a specific issue if another provision of the tax law requires a specific burden of proof with respect to that issue.
There are three categories of people most likely to be audited: people in cash businesses, certain professionals and people taking unusually large deductions.
- Cash businesses are easy targets for the IRS. Many people in these businesses don’t declare all their income, and the IRS knows it. If, for example, your occupation is listed as a hairdresser, waiter or bartender, it may raise a red flag. If you regularly receive cash for your work, be sure to report all the money you earn, including tips.
- Professionals such as doctors, lawyers and accountants are also targeted. That’s because they generally run their own businesses and do their own bookkeeping.
- Large, unusual deductions are easily picked up by IRS computers. Although these deductions may be justified, they may still raise a red flag.
Which Deductions Are Likely to Be Challenged?
The IRS mandates that certain deductions must exceed a minimum percentage of your income before you can claim them. For example, medical deductions must exceed 7.5% of your income, and casualty loss deductions must exceed 10% before you can claim them. Only a small number of taxpayers qualify, so if you claim these deductions, keep careful records.<
The IRS is also likely to look at your contributions to charity. If you deduct more than the IRS’s statistical norms, you may be audited. You must have a receipt containing certain specific information (not just a canceled check) for any single donation of $250 or more. If you do not have a receipt, the IRS may disallow the deduction. A home office deduction may also be questioned. Keep accurate records if you deduct expenses related to a home office.
The IRS may also audit if they receive a tip that you are cheating on your tax returns.
If you are notified that you will be audited, take it seriously but don’t panic. First, read the letter from the IRS carefully and figure out what you are being asked to do. It may be as simple as signing your return. There are three basic types of audits, and the letter will explain which one applies to you:
- A Correspondence Audit is for minor mistakes. A letter from the IRS will tell you what documentation to send them through the mail. Once the IRS is satisfied that it has the correct paperwork, the matter will be closed.
- A Field Audit is one in which the auditor comes to your business or home to verify the accuracy of your return. This type of audit is usually done if the return is complicated and involves business operations. If your records are neat and in order, it will suggest to the auditor that you are a conscientious business person.
- An Office Audit requires that you physically appear on a specific date and time at an IRS facility and bring your documentation. Bring only the documents asked for. Otherwise, you will leave yourself open to an examination of all your records, even if they are not in dispute. If you are unable to keep a scheduled audit appointment, phone and reschedule as soon as possible.
Do I Need Professional Help?
Probably. Taxation is very complicated and technical, and you will benefit from having an expert on your side. If you had an attorney or CPA prepare your return, you may want to bring that person to the audit. Professional tax preparation services will sometimes send someone to accompany you to an audit. Weigh the amount of tax in question against the cost of bringing a professional with you.
Can I Appeal the Findings?
You can either agree or disagree with the auditor’s findings. If you agree, your experience with the IRS is finished upon completion of some paperwork and payment of any outstanding amounts. If you disagree with the auditor, the issues in question can be reviewed informally with the auditor’s supervisor or you can appeal to the IRS appeals office, which is independent of the local IRS office that conducted the audit.
If you do not reach an agreement with the appeals officer, you may take your case to the U.S. Tax Court, U.S. Claims Court or U.S. District Court. The Tax Court generally hears cases before any tax is assessed or paid. The Claims Court and District Court generally hear tax cases only after you have paid the tax and filed a claim for refund.
If you cannot decide to agree or disagree, the IRS has formal procedures to help you make up your mind. Within a few weeks of your audit, you will receive a letter that gives you 30 days to either agree with the auditor or file a formal appeal. The letter will explain the steps to take, depending on your choice of action.
If you do not respond to the 30-day lette r, or if you do not reach an agreement with the appeals officer, the IRS will send you a “statutory notice of deficiency,” giving you 90 days to bring your case to the Tax Court. If you take no action, you lose your right to go to Tax Court, and the IRS will assess the additional tax against you.
If you choose not to hire a tax professional to assist you, then you need to follow several simple rules:
- Don’t rush. Respond promptly to a notification of audit, but don’t hesitate to ask for a postponement if you need time to gather records.
- Don’t lie. Answer questions truthfully, but don’t volunteer information that isn’t asked for.
- Be friendly. A positive attitude will go a long way.
- Keep good records. The burden of proof is initially on you.
- Keep records for at least three years.
- Educate yourself. Read IRS Publication 1, Your Rights as a Taxpayer. You can order this and other tax forms and publications by calling the IRS at 1-800/829-3676.
- Ask for help. Call or visit the IRS for help in preparation of your tax return. Refer to your 1040 instruction booklet for a directory of telephone numbers, for recorded information or “live” help.
- Don’t let the auditor keep your original documents.
- Appeal the audit if you disagree with the findings.
- Come clean. If you know one of your deductions is unsupportable, admit it and pay the tax.
If you have prepared your tax return truthfully and have saved receipts to back up your deductions, notice of an IRS audit should not make you unduly nervous. IRS employees, after all, are only doing the job we pay them to do.