The IRS Audit Process

Generally, your tax return cannot be audited after three years from its original filing date. If you filed before the due date, April 15 of the due date, April 15, the three years starts running from April 15 of the year it was due..

  • If you understate your income by 25% or more on your tax return, the audit deadline is extended to six years.
  • If you file a fraudulent return, there is no time limit on an audit. Tax fraud is conduct meant to deceive the IRS, such as using a false Social Security number. A really big mistake, if done negligently, not intentionally, isn’t fraud. The burden of proving fraud is always on the IRS. And the IRS seldom audits returns after three years even if fraud is suspected.
  • The audit time limit period, called a statute of limitations, starts to run only if and when you file a tax return. Nonfiled tax years are always open to audit. If, however, you haven’t filed and haven’t heard from the IRS within 6 years of the due date of a tax return, you have probably escaped the audit net.

Audit notices are usually mailed between 12 and 18 months after you file return. Generally, if you haven’t heard from the IRS within 18 months you won’t be audited. IRS audit notices are sent by first class mail and never by email or telephone.

Let me know if I can help. Please call me at 817-877-5995 or toll free at 800-651-0528.

Audit Selection-Why me, O Lord?

You just got an examination notice from the IRS. Are you merely unlucky, or are there more sinister forces at work?

Computers and Classifiers

The IRS computer is to blame for more audits, Each year, your tax return data is sent to the IRS National Computer Center where it is analyzed by a computer program called the Discriminant Function. Your tax return is given a numerical DIF the higher the score, the more audit potential the return has.

The IRS has a second computer scoring program to catch people not reporting all of their income. This is a slightly different approach from the DIF program, which relies heavily on deductions and exemptions claimed. This program is called the Unreported Income Discriminate Information Function (UIDIF). It scores individuals based on a high-expense/low-income ratio. In plain English, tax man is looking for folks who look like they are living beyond their means.

According to the IRS Manual, only significant items should be examined. What is considered significant depends on the IRS’s overall view of the return as well as particular items that seem questionable. Factors that are likely to figure into the audit selection process include:

  • Comparative size of an item to the rest of the return. A $5,000 expense on a tax return reporting $25,000 in income would be significant; the same expense on a $100,000 income return wouldn’t be.
  • An item on the return that is out of character for the tax payer. A plumber claiming expenses relating to a business airplane would cause suspicion
  • An item that is reported at an inappropriate place on the return. For example, $2,000 of credit card interest is reported as a business expense. The IRS might suspect that you improperly deducted personal interest as a business expense.
  • Evidence of intent to mislead on the return. Filing a tax return with missing schedules or not providing all information asked for on the forms raises an IRS classifier’s eyebrows.
  • Your gross income. The IRS scrutinizes high earners. If you make over $100.000 per year, your audit like hood is one in 20 versus one in 100 for the general population.
  • Self-employment income. The IRS is most suspicious of people in business for themselves. Sole proprietors are four times more likely to be audited than wage earners.
  • Losses from business and investments claimed on the tax return. If your business and investments show losses on your tax return, the IRS may want to know how you paid your bills. Most likely to be audited are taxpayers reporting a small business loss.
  • Sloppiness and round numbers. A messy return, especially if hand- written attracts the attention of a classifier who may think you don’t take your tax-reporting responsibilities very seriously. Use of round numbers-for example, $5,000 for business advertising, $2,000 for transportation and $1,500 for insurance- is a dead giveaway that you are estimating, not reporting from records.

How the IRS Investigates Your Lifestyle

You can understand the IRS’s focus on lifestyle audits by looking at the IRS training materials for auditors. They look at the following lifestyle-related issues. The standard of living a taxpayer:

  • What does the taxpayer and dependent family consume?
  • How much does it cost to maintain this consumption?
  • Is reported net income sufficient to support this?

The Accumulated Wealth of a Taxpayer

  • How much capital /assets has taxpayer accumulated?
  • When and how has this wealth accumulated?
  • Has reported income been sufficient to pay for these items?
  • If not, how did taxpayer obtain and repay credit?

The Economic Story History of a Taxpayer:

  • What is the long-term pattern of profits and return on investment in the reported activity?
  • Is the business expanding or contracting?
  • Does the reported business history match with changes in the taxpayer’s standard of living and wealth accumulation?

The Business Environment

  • What is typical profitability and return on investment for the taxpayer’s industry and locality?
  • What are the typical patterns of noncompliance in the taxpayer’s industry?
  • What are the competitive pressures and economic health of the industry within which the taxpayer operates?

Other Non-taxable Sources of Funds

  • Do claim of nontaxable sources of support make economic sense?
  • How creditworthy is the tax payer-how many claimed loans?
  • How did the sources of claimed fund transfers obtain those funds? For example, it is unlikely that subsidies will be obtained from countries where dollars are hard to obtain.

Types of Audits

There are three types of IRS audits: correspondence, office, and field. The way the IRS goes about auditing you can produce very different results. A few years back, office audits resulted in additional tax and penalties averaging $1,965 per individual return, correspondence audits $3,817, and field audits a whopping $16,248. For those tax payers who made more than $100,000 per year, filed audits resulted in added taxes, penalties, and interest averaging $35,295! In a recent year, The IRS performed 1.7 million audits.

Correspondence Audits-Please, Mr. Postman

The correspondence audit is by far the IRS’s preferred method of attack. Seventy-eight percent of all IRS audits are by mail. Like it sounds, a correspondence audit comes by first-class mail. The IRS never notifies by telephone or email of the beginning of a correspondence audit .The IRS requests that you mail information or documents instead of meeting with you. This method of auditing is used to verify such things as stock market transactions, real estate sales, and itemized deductions. Amended tax returns are often audited by mail. These audits often result from mismatch of a third-party payment report on a form 1099 or W-2.

You should almost always cooperate with an audit be thankful that you weren’t chosen for a field or an office audit. Unless the documents requested are lost or nonexistent prompetly send copies. Don’t send originals- you won’t get them back. It’s possible to call the auditor to discuss your case. Or, write and ask the auditor to call you. A name and telephone number should be listed in the IRS notice you received. As a precaution, send document copies by certified mail, return receipt requested. Always keep photocopies of everything you send to the IRS.

The office audit is announced by an IRS letter sent to your last known address either setting a time or requesting you to call for an appointment. The letter tells you the year being audited and often specifies documents you are requested to bring with you, such as receipts and canceled checks. It may also list up four specific areas of the IRS wants to examine- such as rental property income, deducted interest expenses, deducted unreimbursed business expenses, and charitable contributions.

Thankfully, the IRS doesn’t expect auditors to examine every item on a tax return. Remember- only significant items are selected by classifiers, although IRS examination group managers may modify the list before the audit appointment.

You don’t have to respond to everything immediately. If you are questioned about unlisted items and you don’t want to answer, just say that you are not prepared to discuss those issues. The auditors will probably drop it, or give you more time to get prepared and set a second meeting date.

Review the Audit Notice Carefully

As By law, the IRS normally has three years to audit you after you file tax return. So, if the year on your notice is more than three years ago, either the IRS made a mistake or the IRS suspects you of fraud or of substantially understating your income. If you believe it’s a mistake, call the number on the notice and ask that the audit be canceled. If you’re told it is no mistake, then head straight for a tax professional’s office.

Your Rights During an Audit

IRS publication 1, your rights as a taxpayer, should be included with your audit notice. It very clearly explains the Taxpayer Bill of Rights. The most important audit rights are to:

  • Be treated fairly by IRS personnel. If you find someone who is not professional, prompt, and courteous, you have a right to speak to a supervisor.
  • Have a representative handle your audit. He or she must qualified to practice before the IRS and have your written power of attorney. With a few exceptions, the IRS can’t force you to appear or even contract you if you send a representative in your place.
  • Sound record the audit, although this isn’t recommended. Taping an audit would most likely only cause the auditor to be unfriendly and work harder.
  • Not have to submit to repeat audits. If you ever audited within the last two years, and the IRS made few or no tax adjustments, you can’t be audited for the same items again. The IRS can, however, examine different items in your return. If you believe you’re being audited again for the same items, complain to the IRS appointment clerk or auditor. The no-repeat audit policy does not apply to examinations of business-related items on an individual’s return.
  • Have proposed adjustments explained. Audit reports are vague, so you are entitled to get a detailed explanation if you ask for it. You can do this by phone or in person. If the auditor refuses, talk to her or his manager.
  • Not be forced to incriminate yourself. You always have this. Constitutionally guarantee right when dealing with the government, even IRS. For example, if you earn your living by robbing banks, the IRS can’t demand that you give details, as long as you report the income. You cannot, however, lie to the IRS about the source of your income. In this case, you should state on your tax return or during an audit that you are claiming the Fifth Amendment- but see a tax or criminal attorney before doing so.
  • Appeal your audit.

What to Expect at a Field Audit

  • Revenue agents’ primary focus is to find unreported income and personal expenses claimed as business deductions. Field audits typically zero in on the following areas of your work and personal lives

Unreported Income. This is the auditor’s number one concern. An agent is particularly suspicious if your small business or profession has a lot of cash transactions. This is why so many restaurant, bar, liquor store, Laundromat, and grocery store owners are audited. The IRS is always looking for the skimming of cash off the gross receipts of the business.

To ferret out unreported income, the IRS uses indirect methods of detection, unless you furnish direct evidence, such as confessing to the auditor that you didn’t report everything.

There are four common methods the IRS uses to probe for income. All four methods have been challenged in federal court; all four methods have survived the challenge. Each one is explained below, with possible defenses you can raise:

  • Net Worth Methodstrong> Using this method, the IRS attributes any increase in your net worth during the year in question to taxable income- unless you offer a reasonable explanation. The IRS tries to establish your net worth- your total assets less your liabilities- at the beginning of the year and then again at the end. Then it compares the two figures to see if your net worth increased over the year. Assets like real estate and stock are valued at their original cost, so appreciation won’t enter into the computation. Typically, the IRS asks for financial statements that may have been prepared for your business or in a loan application. Any increase in your net worth over a prior year will be compared to the income reported on your tax return. If your net worth has increased but your income has not, the IRS will assume you’re not reporting all your income.
    Defense. Show that the IRS’s calculations are wrong or that your net worth increased due to nontaxable factors. For example, you may have inherited money or assets or have a cash hoard accumulated in prior years. The law then shifts the burden to the IRS to negate any explanation you offer before making an audit adjustment.
  • Expenditures method. The IRS totals up all of your known and estimated expenditures for the year and compares the result with your reported income. If you spent more than you claim you earned, the IRS will attribute the difference to unreported income. Defense. Show the IRS didn’t add and subtract correctly or that money you spend was from nontaxable sources, such as loans, gifts, inheritances or prior accumulations.
  • Bank deposit method. this is the IRS’s favorite indirect method of proving unreported income and is always used by field auditors, the IRS simply tallies up the deposits made in all of your bank accounts and compares the total with your reported income if you have deposited more than you claim you earned, The IRS will attribute the difference more than you claim your earned, the IRS will attribute the difference to unreported income.

Some business owners take great pains to skim receipts, but then stupidly put that money into their bank accounts. Financial records can easily be obtained by the IRS from your bank or stock broker if you don’t produce them voluntarily. Revenue agents almost always perform a bank deposit analysis early on in a field audit.

Do your own bank deposit analysis before the audit. Make notes on your bank statements that explain the source of the deposits. There can be any number of explanations when deposits exceed taxable income-loans. Redeposit of bad checks, transfers between accounts, inheritances and gifts received, sales of assets, and the like.

How an Auditor Approaches an Examination

The tax code gives the auditor wide latitude and authority to pry into your financial affairs. The basic tools in the auditor’s kit are the interview, summons, IRS and other government files, and contracts with third parties, like your bank, who have knowledge of your finances.

Information Document Request. Along with your audit notice may come a separate form called an Information Document Request, or IDR. An auditor commonly issues multiple IDR’s if the audit, usually a field audit, continues beyond one meeting. an IDR is a written solicitation of records or other papers either in your possession or accessible to you. Typically, bank statements and canceled checks are listed on an IDR. The IRS knowsthe truth of the words of a former U.S. Supreme Court justice that “a person can be defined by the checks he writes.”

Ordinarily, you will be given until a follow-up audit appointment or a few weeks to mail these things to the auditor. A sample IDR follows.

If You Don’t Give Auditors What They Ask For

When you don’t give the auditor information that has been requested, the auditor has three choices:

  • Drop it. You’d be surprised how many auditors back off or are forgetful they are working on many other cases. If they have most of the information requested from you, they may let it slide.
  • Go further without your cooperation. Auditors call, write, or issue summonses to third parties, such as your bank, for records of your transactions. Auditors can, but rarely do, summons (order) you to appear before them and provide information.
  • Issue an examination report anyway. The auditor can issue the report based on the information in hand and estimates for the missing income or expense data. By far, this is the most likely consequence of your not cooperating with and auditor.

Your Audit Goals

You have two goals in the audit:

  • To minimized the financial damage. Because the odds are great that your audit will end with a tax bill, your goal should be damaged control- keeping your liability as low as possible. But, don’t go to in with a defeatist attitude. If you owe no money, try to prove it. Just don’t have unrealistic expectations. In a recent year, audits resulted in $19 billion in a additional taxes and penalties, and about $600 million in refunds- a ratio of 32 to 1 against you.
  • To prevent expansion. Office audits are initially limited to the items listed on the audit notice. If auditors see other problems, however, they will pursue them. This often happens when you show an auditor a document that you weren’t obligated to show or you make a slip of the tongue. As a rule, never show the auditor anything not specifically related to the tax year in the audit notice. For example, before showing your check registered or business diary, edit out the portions that portions that relate to personal matters or that into other years.

Audits may be expanded into other tax years. An auditor may get permission from his or hers manager, to examine any open tax years tax year if it is likely to be fruitful. Open years are those within three years of when a return was filed, or six years if the IRS finds serious underreporting.

Don’t show the auditors copies of tax returns for years other than the one in the audit notice. If the IRS expands the audit, you should demand an official written notice from the auditor.

Documents To Bring To The Audit

The audit notice includes a list of documents you are supposed to bring to the audit. You may want to bring additional documents you need to explain or reconstruct missing records. IRS Publication 552. Recordkeeping for individuals, shows how the IRS wants you to keep you records. Don’t worry if you haven’t followed all the IRS suggestions. You just need to be able to show income and expenses to the auditor in some understandable manner, listed here are specific documents to bring. >

Canceled checks and Receipt.Take only the checks and receipts relating to the areas listed in the audit notice. Rummage through all your checks and receipts. If it appears that you are spending more money that you are reporting, the auditor may become suspicious . you can bring your credit card or bank account statement instead of a cancel check. (IRS Revenue Procedure 92-71.)

Books and Records, if you operated a business. You aren’t required to have a formal set of books as long as the auditor believes your records reflect your true income expenses. A check register may take the place of set of books, if it’s backed up by canceled checks and receipts.

If your business has no records, you can be fined for failure to keep adequate records. The auditor can make up missing records by guesswork. For example, the auditor may double your gross receipts based on published industry or government statistics.

Appointment books or business diaries. If you claimed travel or entertainment expenses, you will need a writing showing dates and times the expenses were incurred, their business purposes, and who was visited of entertained. If you have no diary, you can write one up for the audit, but tell the auditor it is a reconstruction if you are asked.

Auto logs. Auto logs aren’t required by law- despite what some auditors say-but they will help you prove business auto expenses. Again, you can create one after the fact, but be up-front about it Repair and maintenance receipts should have odometer mileage written on them, and your diary may have notations of trips and expenses.

Escrow papers. These are necessary if you claim rental property depreciation deductions to show how much of a deduction you are entitled to. They are also required if you sold the property.

Receiving the Examination Report

When the auditor completes the work, you will be handed or mailed IRS Form 4549, an examination reports. It shows changes proposed to your tax liability for the years under audit, And for any other open years if the auditor expanded examination. The report also provides a brief explanation for each change, such as “You did not prove the amount shown was a rental expense.”

Understanding the Examination Reports

The total amount of taxes, penalties, and interest added by the audit is shown on you report. Each change is listed, the tax code section cited, and a general explanation given. As started, most explanations are vague. You are usually not specifically told how you failed to prove your case. An auditor must tell you where you failed.

The total amount of taxes, penalties, and interest added by the audit is shown on you report. Each change is listed, the tax code section cited, and a general explanation given. As started, most explanations are vague. You are usually not specifically told how you failed to prove your case. An auditor must tell you where you failed.

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