For any audit, IRS agents must review the following four issues:
- Income: The IRS will want to see bank statements, records from the sale of assets, documents relating to prizes, alimony, pensions, and state and federal tax refunds.
- Previous audits: If the taxpayer previously had an audit, the agents will review information about when the previous audit took place, the results, and any recent correspondence the taxpayer has had with the IRS.
- Other returns: Agents will examine whether the taxpayer filed subsequent and prior years’ returns on time and whether adjustments were necessary.
- Penalties: IRS agents must inquire whether the taxpayer has previously been assessed tax penalties. Of course, they will determine whether penalties should be assessed as a result of the current audit.
All audits begin with the taxpayer receiving a notice in the mail from the IRS. People should not panic if they do receive correspondence from the IRS in the mail. In fact, what they receive may not even be an audit notice at all, but an “automated adjustment notice,” (also called a CP2000) informing them about additional taxes they owe. Automated adjustment notices reveal errors taxpayers made in computing income or taxes. The IRS sends automated adjustment notices to certain taxpayers because they failed to report some income to the IRS which was reported to it on a 1099 form, such as dividends or interest.
Even though a taxpayer receives an automated adjustment notice does not mean that the taxpayer must pay the amount assessed without question. In fact, the IRS itself makes miscalculations of taxes or enters income data about incorrectly. Federal law gives taxpayers the right to appeal an automated adjustment notice in writing within 60 days of receipt of the notice.
If people receive a notice from the IRS that they will be audited, they should first contact the revenue agent assigned to their case to schedule a mutually convenient time to meet. The taxpayer bears the burden of proof, which means the taxpayer must prove that the tax return in question, as well as the taxpayer’s records are accurate and complete. The taxpayer will be assessed additional taxes if the taxpayer cannot prove the questionable aspects of the reported income and/or deductions. This possibility makes it important to maintain organized and accessible financial records.
Audited taxpayers should expect the IRS to ask some or all of the following questions or look into the following issues:
- Did the taxpayer report all of his or her business sales and receipts?
- Did the taxpayer write off any personal living expenses as business expenses?
- Does the taxpayer’s lifestyle seem to exceed the amount of reported self-employment income?
- Did the taxpayer write off automobile expenses for travel that was not businessrelated?
- Did the taxpayer claim large business entertainment expenses?
- Are the taxpayer’s workers classified as independent contractors when they are really employees?
- Does the taxpayer make payroll tax deposits in a timely manner?
- Did the taxpayer report all cash transactions—especially large cash transactions?
When the IRS revenue agent completes the audit, the taxpayer will get a report describing the agent’s recommendation and a statement of the amount of money the taxpayer owes. The agent will probably ask the taxpayer to sign a waiver of the appeal rights at that time. When the agent asks the taxpayer to sign the waiver the taxpayer has three options:
- Go ahead and pay the additional tax; if the taxpayer disputes the additional amount, the taxpayer can file for a refund.
- The taxpayer requests an appeal with the IRS appellate division. The taxpayer does not pay the tax bill and interest on the tax bill continues to accumulate during the appeal process. Even so, this is a small item compared to the tax savings that result from most appeals.
- The taxpayer signs the waiver and pays the tax.
Occasionally the IRS will conclude that a taxpayer knowingly violated the tax laws. In these cases the IRS can recommend to the U.S. Department of Justice that the taxpayer be charged with a crime. Some of these taxpayers are prosecuted for specific tax violations, including knowingly failing to file a return or knowingly filing a fraudulent return. Recently, the IRS criminal referrals have been increasingly based on statutes relating to money laundering, drugs, and other currency violations.
It is important to remain as objective as possible during an audit. The audit is, after all, strictly about numbers. However, taxpayers need not be subject to an auditor who is rude or unpleasant. In such cases, taxpayers are legally entitled to request the assignment of a different auditor.