What is an IRS audit?

The IRS can challenge the accuracy of a tax return through an audit or, in IRS terminology- an “examination.”   Audits involve an IRS auditor’s (tax examiner, tax compliance officer, or revenue agent) review of the books and records of the taxpayer to determine the accuracy of a return.

What do you need to know about IRS audits?

The goal of an IRS audit is to determine whether the taxpayer reported the “substantially correct tax liability”:  the IRS usually does not review the entire return.  Most audits review whether the taxpayer reported all of their income on the return and any other “large, unusual, or questionable” item(s) found on the tax return.

Audits have to follow a process that protects taxpayer rights:   The process is referred to as “deficiency procedures.”  These procedures allow the taxpayer a right to appeal the findings of an audit before the tax is assessed and paid.   In the audit, the taxpayer is given time to provide documentation and evidence to support items reported (and not reported) on the tax return.  At the end of an audit, the IRS may or may not propose changes to the return (IRS calls these changes “adjustments”).   The taxpayer will have the right to appeal the adjustments in the IRS Independent Office of Appeals and Tax Court prior to the tax being assessed.

There are many ways you can be selected for audit:  the most common selection method is a refund hold scenario.  If the IRS suspects an obvious error on the return, it may freeze the taxpayer’s refund and audit the return.  Other common sources of audits is computer-selection (based on how much the return has the probability of error), an IRS compliance project (the IRS decides to concentrate audit resources on an issue or type of taxpayer, like a small business), or the taxpayer is selected because they have related transactions to another ongoing audit (like a partner in a partnership).

There are three types of audits:  the mail (correspondence), office (“desk”), and field audit.  The mail audit is the least intrusive.  Both the office and field audits are done face-to-face, with the auditor interviewing the taxpayer and/or their representative.  Office and field audits are more involved and usually involve more complicated taxpayers and issues.

Most audits are automated mail audits:  75% of all audits are mail audits in which the taxpayer needs to answer IRS questions and provide documents to support the accuracy of their filed tax return.  The most common mail audit issue is the earned income tax credit.   The mail audit process produces automated letters which can cause problems (tax assessments, lost appeal rights) for the taxpayer if they do not respond timely.

A field audit is rare- and should be taken seriously by the taxpayer:  a field audit occurs at the taxpayer’s home or place of business.  It is the most comprehensive of all IRS audits and is completed by an IRS revenue agent who has special training and skills to handle more complex situations.  In these audits, the IRS is also looking closely for unreported income and possible tax evasion.  Taxpayers should often engage a professional to work with the IRS in these complex audits.

IRS makes changes in 90% of all audits:  the IRS knows which returns to audit.  9 out of 10 audits end up with a change to the return.

IRS audits trigger the most serious penalties, including criminal prosecutions:  The most common penalty is a 20% accuracy penalty.  However, most IRS tax evasion cases start out as IRS field audits.   Tax evaders can be criminally prosecuted but also face a 75% civil fraud penalty.

Questions we hear often:

Background on IRS audits

How often does it happen?  In 2018, the IRS conducted 991,368 audits- of which 3/4ths are mail audits.   The number of audits is down compared to 2010, where there were more than 1.7 million audits completed by the IRS.   Today, an individual taxpayer has a 3 in 500 chance of being audited.

Most often audited issue?   By far, the most audited issue by the IRS is the earned income tax credit.  EITC has a 25% error rate, and the IRS often holds refunds of the EITC if they suspect an error or fraud.   The only way the IRS can continue to hold the refund is audit the taxpayer.  Other issues include charitable contributions, small business deductions, and other credits.

How long does it take to resolve? 2- 18 months.  The office audit can be completed quickly if the auditor and the taxpayer can resolve the issues in first meeting at the IRS’ office.  Mail audits take a few months because they it takes the IRS time to process responses and send follow up notices to the taxpayer by mail.  Field audits can take the longest as they are the most comprehensive of all audits and usually involve more complex tax situations or transactions.

Questions we hear often:

Most likely solution(s) for an IRS audit

Mail audit response: A timely filed, complete audit response to the IRS that proves the accuracy of the reporting of each item under audit.  This response should include the taxpayer’s supporting documents.  This response should also dispute any penalties and request an IRS appeal should the IRS tax examiner disagree with the response.

Office/field audit process:  Taxpayers subject to face-to-face audits (office and field audits) need to follow the steps in the audit process  – from preparing for the audit, attending the initial interview, providing documents and evidence to support the tax return accuracy, and finalizing the audit with the IRS auditor.

Appealing adjustments to the IRS Independent Office of Appeals:   Some audits end up in disagreements with the IRS auditor.  The first step is to request a conference with the auditor’s manager.  If agreement cannot be reached with the IRS auditor, then the taxpayer can appeal to the IRS Independent Office of Appeals.   If an agreement cannot be reached in Appeals, the taxpayer can also timely request a review by the courts.

Other potential solutions for an IRS audit

Audit reconsideration:  Reconsideration is commonly  applicable for mail audits in which the taxpayer was not given an opportunity to respond before additional tax is assessed.  if a taxpayer missed the deadline to respond or have additional information to provide, they can request reconsideration by following audit reconsideration procedures.

Offer in compromise- doubt as to liability:   When the taxpayer has more information to present that would overturn prior audit results, the taxpayer can request that the IRS formally reconsider the audit results through an Offer in compromise- doubt as to liability (Form 656-L).  This request is very similar to an audit reconsideration request.

Steps to resolve a mail audit

The mail audit is the most common type of audit.  The taxpayer will need to timely respond with evidence to support the accuracy of their return.  Mail audit resolution involves a complete response, with documentation to the IRS:

  1. Review the audit letter:   Analyze the year and items under audit.  Note the deadline date (usually 30 days) to respond.
  2. Gather your original tax return documents for the year in question:  Gather the tax file that has the supporting notes and documents for the audit year in question.
  3. Create a response for each issue under audit:  Each issue selected should have a worksheet that provides your facts, the documents to support the item reported on the return, and any other information needed.  For example, if the IRS is auditing charitable contributions, the taxpayer should provide a list of all contributions, and attach supporting documentation for each donation.
  4. Reconstruct evidence, if needed:  Many times, taxpayers do not have their information to support the item on the return.  Taxpayers can reconstruct the item by listing the amount on the worksheet and how the amount was derived.   The taxpayer can also go back and get copies of receipts from the original source, if needed.    In some cases, taxpayers can also support deductions by providing an explanation and detailed list of the expenses that make up the deductions taken, even though they may not have receipt for each expense item.  For example, the taxpayer may be able to reconstruct medical expenses by going through their insurance claims or pharmacy orders.   If there are amounts in which a receipt cannot be found, the taxpayer can create a worksheet showing the date, amount, and expense paid to the medical provider.  The IRS auditor has the discretion to accept this statement from the taxpayer even though the original receipt was not found.
  5. Review the IRS decision:  The IRS can propose adjustments to the return (additional tax or refund) or decide the return is accurate (called a “no-change” audit).  The taxpayer should review the audit report (likely Form 4549) and the explanation of adjustments (Form 886-A).  If the taxpayer agrees, they can sign the form and return it to the IRS.  If they disagree, they should contact the IRS auditor and make their case.  If the auditor does not agree, the taxpayer can request to speak with the auditor’s manager.  If an agreement cannot be reached with the manager, the taxpayer can then ask to appeal the findings to the IRS Independent Office of Appeals.  Agreements or no-change decisions stop the audit process here, unless the taxpayer needs to set a payment plan or other collection alternative on the amount owed.
  6. Appeal disagreements:   The taxpayer will need to prepare a protest outlining their areas of disagreement.  For mail audits, taxpayers can usually use Form 12203, Request for Appeals Review, to state their reasons for appeal.  Taxpayers must appeal timely, that is, within 30-days of the receipt of the examination findings letter (usually IRS Letter 525 or 915).  Taxpayers who miss the 30-day timeline can petition Tax Court and/or request audit reconsideration.
  7. Resolve issues in Appeals:   The taxpayer will attend the appeals hearing (usually by phone for mail audit cases) and present their facts, law, and argument to reach agreement.   If an agreement cannot be reached, the taxpayer will receive a Statutory Notice of Deficiency (IRS Letter 3219 called the “90-day letter”).  The taxpayer can request another appeal with the Tax Court or pay the balance owed and seek other remedies (claim for refund procedures).

Questions we hear often:

Steps to resolve an office or field audit

Office/field audit resolution involves managing the four phases of the audit process:

Phase 1- Preparing for the audit:  In this phase, the taxpayer will gather initial documents and information requested by the IRS.  The taxpayer will conduct a “mock-audit” that will simulate the questions and techniques that will be used by the IRS auditor.  In the mock-audit, the taxpayer (and likely their tax representative) will complete such items as: reconciling their income to IRS and taxpayer records (Including bank accounts), gathering information and documents on selected audit issue areas, and reviewing the taxpayer’s finances.  The goal in preparing is to be able to address the IRS auditor’s concerns and issues selected in the examination as well as to reconcile that all income is accurately reported on the return.

Phase 2 – The initial interview with the IRS:  In the first meeting with the IRS, the taxpayer will answer questions about the taxpayer’s finances, business, investments, and tax return reporting.  The taxpayer will provide information requested by the IRS to support items on the return.  The IRS may request more information at the end of this meeting.  In office audits, the IRS may issue a preliminary examination report at the end of the initial meeting (usually a 2-hour meeting).  In field audits, the initial meeting is just the beginning of the audit for the IRS.  The field auditor (called a revenue agent) will likely issue more requests for information (called an information document request – or Form 4564) and ask more questions throughout the audit process.

Phase 3 – Issue development:  For the field audit, this is the usually the longest phase of the audit process. In this phase, the IRS auditor will decide what issues to pursue and request more information to support a change to the tax return.  The IRS auditor will also decide whether or not to pursue penalties.  At the end of this phase, the IRS will issue an audit report (Form 4549) proposing adjustments or indicate that the return is accepted as filed (no-change).

Phase 4 – Issue resolution and closing the audit:  After the IRS proposes any adjustments and additional tax due, the taxpayer is offered an opportunity to agree or to contest the adjustments with the auditor and their manager.  If the taxpayer agrees, the audit is complete.  If the taxpayer does not agree and a resolution cannot be reached with the auditor or their manager, the taxpayer can proceed to IRS Appeals and/or the courts for final resolution.

Taxpayers know their audit is complete when the final adjustments to the tax year/form are posted to their IRS account transcript and IRS notice CP 22E is received (IRS letter 590 if the audit is a no-change).

Note that most office/field audits are handled by the taxpayer’s CPA, enrolled agent, or attorney – i.e. tax professionals experienced to handle matters before the IRS.

Questions we hear often:

Can you appeal a disagreement in an audit?

Yes, proposed audit assessments can be appealed if the taxpayer timely requests an appeal.  The taxpayer has four appeals choices:

  • Informal manager conference:  at the end of the audit, meet with the IRS auditor’s manager to ask the manager to intervene on disagreements with the auditor.
  • Appeal with the IRS Independent Office of Appeals:   timely petition (within 30 days after the auditor’s notice) Appeals to have an appeal officer have a fresh look at the case.
  • Petition the US Tax Court:  within 90-days after the receipt of the Statutory Notice of Deficiency (Letter 3219), file a petition with the US Tax Court to resolve the dispute.  In Tax Court petitions, IRS attorneys will often try to resolve the case outside of the court – including allowing the taxpayer to have their case heard in Appeals if the taxpayer has not already been to IRS Appeals on their case.
  • Follow claim for refund procedures: if the 90-days expires to petition Tax Court, the tax is assessed.  Once the tax is assessed (90 days after IRS Letter CP 3219), then the taxpayer must file claim for refund procedures, request audit reconsideration, or request an offer in compromise- doubt as to liability to resolve the issue.  If the taxpayer has not paid the tax, they may have appeals opportunities in the collection process (called a Collection Due Process hearing) to contest the tax if they have not already had an appeals opportunity in the past.

Questions we hear:

Audit best practices

A taxpayer will get the best outcome in an audit if they follow these best practices:

  • The mail audit response format is important.  One complete response in a mail audit will streamline the resolution of the audit. Mail audit responses are worked in a first in-first out basis by IRS tax examiners.  The response should include a cover letter that provides an explanation of your agreement and disagreement.  Attached to the cover letter should be the audit letter, a summary of each issue under examination (list of amounts paid, reason for allowance, etc.), and any supporting documents and schedules needed.  If penalties are proposed, the taxpayer should also provide their disagreement in the cover letter and a statement of why the penalties should not apply (i.e. their reasonable cause arguments).  Finally, the cover letter should also request an appeal if the IRS disagrees with the response.
  • If you do not have documents, you can recreate them or provide “oral testimony”:  the IRS can accept your word- it’s called oral testimony.  Reconstructing a list of expenses paid that make up a deduction may be allowed by the IRS auditor.
  • Attach and explain supporting documents.  The taxpayer should provide an explanation of the information provided in an audit.  This can be done by providing a cover sheet that explains the taxpayer’s position and documentation for each issue under audit.  For example, if the IRS is auditing charitable contributions, the taxpayer can provide a cover sheet showing the list of contributions made (date, amount, and charitable organization), and reference the cancelled checks and/or contribution acknowledgement statements.  This will help the IRS quickly allow the item in question.
  • Retain a copy of all responses and don’t give the IRS original documents.   The taxpayer should keep a copy of all responses to the IRS in an audit.   Also, provide only copies of receipts to the IRS and retain the originals for your records.
  • Always reconcile income before meeting with the IRS in an office or field audit.    In an office or field audit, always reconcile the income on the return to the IRS wage and  income transcripts for the taxpayer.  Also, reconcile all deposits in all financial accounts.  Categorize each deposit into both taxable sources (i.e. income) and non-taxable sources (i.e. loans, gifts, etc.).  The IRS is likely going to do these two minimum income checks in an audit.
  • Request an appeal if the IRS disagrees.    If the IRS disagrees and you do not request an appeal within 30 days, the IRS may automatically proceed to assessing the tax.  If you timely request an appeal, the IRS must send your case to the IRS Independent Office of Appeals for reconsideration.  Failure to request means that the taxpayer’s only recourse is to dispute the tax owed in Tax Court or to request reconsideration.
  • Get professional representation for face-to-face audits.  Office and field audits are more in-depth audits and involve complex IRS audit techniques.  Taxpayers have greater risk for long audits that will include multiple years and likely penalty assessments.  Tax pros experienced in practicing before the IRS will be able to anticipate questions, protect your rights, and get the best outcome in the audit.