Tax audit is one of those dreaded phrases in many people’s vocabulary, but it doesn’t have to be.
Even the most upstanding and honest taxpayer can be selected for an audit.
A tax audit or IRS audit refers to the process where the Internal Revenue Service (IRS) reviews the financial information on a taxpayer’s tax return, such as income and deductions, for accuracy. In many cases, the IRS only needs more information to back up or clarify the numbers on your tax return.
Understanding the tax audit process is an effective way of alleviating some of those fears associated with being selected. Here’s a comprehensive guide to understanding and preparing for an IRS audit should you ever be selected.
What happens during an IRS tax audit?
There are several different types of IRS audits, so there are also different procedures depending on the type of audit. However, there is an overall general procedure followed for all IRS tax audits.
To begin, there is a tax return filtering process. All tax returns are processed by a computer that assigns two scores. A DIF or discriminant function score assesses the potential changes on a return, and a UDIF score assesses the potential for unreported income.
If a return receives a high score, it is then sent to an IRS reviewer who manually goes over the return. The reviewer then selects the returns that have the greatest potential for error or the greatest potential for additional revenue and sends them to local field offices where an IRS agent will conduct the detailed audit work.
Once the selection process is complete, the IRS sends an audit selection notice out to the taxpayer. An individual taxpayer’s selection for a tax audit typically takes place within a year from when the return was filed. The tax audit is then conducted by mail correspondence, office, or field interviews.
Once the type of audit is determined, the taxpayer must gather all supporting documents for the item(s) in question and either mail these items to the IRS or be prepared to meet with an agent to answer questions directly.
The auditor reviews the additional financial information the taxpayer provided and ensures all tax laws are being followed. An audit report is then issued to the taxpayer based on the auditor’s findings. The taxpayer can either agree with the report, submit payment, if required, and the audit is closed, or the taxpayer can disagree with the report and work with the auditor to resolve the dispute or take the dispute to the IRS Independent Office of Appeals.
Remember, as the taxpayer, you can choose a certified public accountant (CPA) or enrolled agent (EA) to represent you when dealing with the IRS. Deferring to their expertise can also help to alleviate stressors associated with an audit.
What triggers an IRS audit?
There are certain red flags that trigger an IRS audit. The two items that trigger audits the most are unreported income and reporting an excessive amount of deductions.
Here are the most common IRS audit triggers explained:
(Please note that any number of these triggers could result in only a mailed notice of discrepancy rather than a formal tax audit, however based on the high scoring mentioned above, a tax audit could ensue.)
1. Unreported income
Since the IRS gets copies of your Form W-2s and 1099s, they can do a crosscheck to ensure that all of your income reported on these forms matches the information reported on your tax return. An audit can be triggered if there is a mismatch.
2. Taking the home office deduction
The home office deduction can be taken by those who are self-employed. However, the IRS examines this deduction closely. In order to claim this deduction, you must use the area that you are claiming as a home office exclusively for your business, and your home must be your principal place of business. You can deduct expenses such as homeowners insurance, mortgage interest, renters insurance, and utilities based on the area used as a home office, or you can deduct $5 per square foot of your home office for up to a maximum of 300 square feet. Be sure to keep records of all of these home office expenses and be prepared to prove that this space is used exclusively for business purposes.
3. Reporting several years of business losses
It’s fairly typical for many businesses to have more expenses than income, especially when first getting started, but if your business never makes a profit or barely breaks even for a significant number of years, then the IRS begins to get suspicious. For example, in many industries, if you don’t have a profit in three out of the last five years, then the IRS begins to view the activities as more of a hobby than an actual business. Be sure your business activities support a for-profit motive, have a business plan, and maintain records of revenue and expenses to prove it’s an actual business.
4. Unusually large business expenses
The IRS looks for inconsistencies in expenses and deductions compared to other businesses in the same industry. Separate your business and personal expenses by having separate bank accounts and credit cards for personal and business transactions. Keep detailed records of your business expenses to prove their business purpose.
5. Claiming your car is used 100% for business
You’re less likely to get flagged if you allocate the use of your car between personal and business use. Keeping a mileage log will prove to the IRS how much time the car is actually used for business.
6. Unreported or changes in capital gain income
Stock is taxable when you sell shares, unless they are in a tax-deferred retirement account or you are below certain income levels. The gains and losses are reported to you and the IRS on Form 1099-B and should be reported on Schedule D on your tax return. Be sure to include information from all 1099-Bs.
7. Unreported cryptocurrency
Cryptocurrency has recently become a hot topic, and a check box indicating the presence of cryptocurrency trading is even placed at the top of Form 1040 so it can’t be missed or overlooked. Cryptocurrency needs to be reported if you received any for income or if you had a gain or loss from selling it. Virtual currency is treated like property for tax purposes. Be sure to report all Form 1099-Bs and Form 1099-Ks, if provided, because the IRS will have those on file as well.
8. Large charitable contributions
Charitable contributions are tax deductible if you itemize. You need to be sure to have supporting documentation to substantiate large noncash donations because this will catch the IRS’s eye for potential tax fraud.
9. A higher income bracket
Earning more money is not always a good thing when it comes to your tax return. The more you earn, the more likely you are to be audited.
10. Claiming the Earned Income Tax Credit
There is one exception to the IRS’s tendency to audit more higher income taxpayers. These are lower income taxpayers claiming the Earned Income Tax Credit. This is a refundable credit for low and modest income taxpayers. If you claim this credit, your return will be subject to more IRS scrutiny.
The IRS is also more likely to audit returns with mistakes such as mathematical errors, estimates versus actual numbers, or incorrect social security numbers.
What are the chances of being audited by the IRS in 2022?
The chances of being audited in 2022 are relatively slimmer than usual. Not only are the IRS audit rates at historical low levels, but the IRS is currently also understaffed and underfunded. The IRS examined .4% of all tax returns last year in 2021. By avoiding these triggers or red flags, you will have a lesser chance of being audited.
What types of IRS audits are there?
When the IRS requests more information regarding your tax return, they can request it in one of the following ways.
1. IRS correspondence audit
The correspondence audit is where the IRS mails you a letter requesting more information to back up your tax data. A simple audit letter from the IRS may be issued due to a math error, omission of income, or request documentation supporting the deductions on your return. These matters are dealt with by replying to the correspondence as instructed by the IRS audit letter, which typically means mailing in additional documentation to support the item in question by the due date on the letter.
2. IRS office audit
With the office audit, the initial audit notification comes by mail, but the taxpayer must go to the IRS office and meet face-to-face with an IRS agent. This letter may be received due to any number of issues with business revenue, itemized deductions, or rental expenses and income. The letter will indicate the supporting documents that you will need to bring with you. This audit is more in-depth than a correspondence audit.
3. IRS field audit
Field audits involve in-person meetings with revenue agents at the company’s place of business or the taxpayer’s residence. These audits are quite detailed and are mainly for reviewing financial records, inventory, interviewing employees, and touring the facility to get a better understanding of the business.
4. TCMP audit
The IRS also conducts Taxpayer Compliance Measurement Program audits to ensure taxpayers are complying with all tax laws and updating their DIF scores. Unlike other audits, the TCMP audit requires full documentation for every detail of the taxpayer’s return including contracts, bank statements, receipts, and invoices to substantiate the amounts claimed.
IRS audit penalties
There are several penalties that the IRS can impose depending on the audit results. The most common penalty assessed is the accuracy-related penalty imposed on taxpayers for understated amounts on their tax returns. A 20% accuracy-related penalty is assessed based on the amount of understatement.
If you realized you owed taxes, but intentionally didn’t pay them, the IRS can assess a civil fraud penalty of 75% of federal tax not paid due to fraud. IRS audits can also lead to criminal charges. Criminal charges can stem from tax evasion, filing a return that is false, not filing a return, or intentionally failing to keep supporting financial records or deliberately failing to pay estimated taxes.
Sometimes you can avoid the underpayment penalties with something known as the ‘reasonable cause exception.’ To determine if this exception is applicable or not, the IRS decides if the taxpayer made an effort in good-faith to pay the amount of tax owed. You can also file an appeal if you disagree with the results of the audit.
Step-by-step how to prepare for an IRS tax audit
There are several steps you can take to better prepare yourself for an IRS audit. The better prepared you are, the smoother the audit will go.
Step 1. Study up on your rights.
Do the research. Familiarize yourself with the type of tax audit that the IRS has requested, the audit process involved, and your options after the audit report has been issued.
It’s also important to know your rights as a taxpayer during the audit process itself. You have the right to courteous and professional treatment by the IRS, as well as confidentiality and privacy regarding tax matters. You have the right to know why the information is being requested, how the information will be used, and what the consequences will be if the information isn’t provided. You also have the right to representation and to appeal disagreements before the IRS and the courts.
Step 2. Digitize your receipts.
Digitizing your receipts makes an audit run much more smoothly. Otherwise, you’re going to be frantically flipping through a pile of paper receipts, some of which you may not even be able to read due to fading, crumpling, or water damage, just to find that one receipt that backs up the information on your tax return.
A receipt scanning service such as Shoeboxed.com is a huge benefit when facing IRS audit prep. Shoeboxed provides an envelope with prepaid postage, if within the U.S., for users to fill with their paper receipts and mail to Shoeboxed’s office. The receipts are then scanned, verified by humans, logged into the user’s Shoeboxed account, and stored.
During an audit, if asked about a certain transaction, you can use the search feature and quickly pull it up on Shoeboxed.com instead of having to flip through hundreds of physical receipts. Shoeboxed’s service will digitize all of your receipts in preparation for an IRS audit.
Step 3. Organize your records.
Keeping your records organized is essential when preparing for an IRS audit. Keep all pertinent tax records and supporting documents in one place so they’re easy to find. If you’re missing a document, request a duplicate from the vendor or financial institution. You should have all bank statements, tax returns from the last three years, receipts, and all financial statements if you own a business. Be sure to have all documents sorted by year and type of income or expense, with the year being audited closest at hand. Also, include a summary of all transactions by year. Having your records organized will speed up the audit process.
Step 4. Hire a tax representative.
Instead of handling the audit yourself, you can hire a tax representative to take care of it for you. If you do hire a tax representative, you will need to sign Form 2848 or power of attorney form which gives the representative authority to represent you before the IRS. Hiring a tax representative is a good idea when the issues are technical in nature or require someone to interpret tax law. While hiring a tax representative can be a bit pricey, it may save you money in the long run.
Top tips for a successful IRS tax audit
While the initial thought of an IRS audit can seem intimidating, taking the time to prepare can save time and make the process less stressful.
Here are our top tips for a successful IRS audit:
Tip #1. Stay calm and don’t panic.
The IRS is not out to judge or get you. They simply want to make sure you reported your income correctly, complied with all tax laws, and paid the amount of tax you owe. By staying calm, you are more likely to get through the process in a more organized, clear-headed, and focused manner, which will save you and the auditor a lot of time.
Tip #2. Determine the type of audit being requested.
Determine the type of audit you will be undergoing and take the time to research and understand the process for that specific type. Knowing what to expect can alleviate some of the stress and leave you better prepared.
Tip #3. Respond thoroughly and promptly to any IRS correspondence.
Ignoring audit correspondence will only cause more trouble and you may have to pay increased penalties and fines. Be sure to comply with all of the IRS’s requests by providing the specific information requested and ensure it is submitted in a timely manner. Document requests will have the deadline clearly indicated on the correspondence from the IRS.
Tip #4. Collect all substantiating documents.
The IRS just wants to make sure that both of you have the same financial information and documentation. Be sure to collect all relevant information you have to back up the figures on your tax return. You will need all forms documenting your income and receipts to back up your claimed expenses. The more relevant documentation you have, the smoother the audit process will go.
Tip #5. Prepare for relevant questions.
If you’re subject to an in-person field audit, you will be answering questions directly from the auditor. You will be asked follow-up questions so that the auditor can get a clearer picture of your income and expenses. It’s best to have all relevant information with you at the meeting so you can quickly pull up any substantiating documentation to immediately nip questions in the bud. Be sure to only respond to the specific question asked because if you go off on a tangent or offer up too much information, you may open another can of worms that can lead to additional work.
Tip #6. Consider using outside help.
There’s nothing wrong with getting outside help if you’re feeling intimidated or overwhelmed. Your CPA or other tax expert is the ideal person to help get you through the process. While using outside help can be a little pricey, their expertise just might save you money in the long run.
Tip #7. Appeal if you don’t agree with the IRS.
If you don’t agree with the IRS’s findings, you generally have 30 days from the date of the letter to appeal the results. So the initial audit report issued isn’t the final say. You do have recourse to have your return reevaluated.
Tip #8. Be patient.
Ideally tax audit issues could be resolved overnight, but they likely won’t. You may be exchanging information with the IRS for weeks and months, so remain diligent, respectful, and patient.
Frequently asked questions about tax audits
How long do tax audits take?
The statute of limitations states that you can be audited up to three years after you file your tax return. According to the IRS manual, the tax audit timeline is either 26 months after the return was filed or the due date of the return, whichever is later. The average time period to complete a tax audit is five to six months. Some can be resolved even faster. The four things that will hold up an audit are if the IRS finds a lot of adjustments on your return, if you own a small business, if there are IRS audit penalties, or if you disagree with the auditor’s adjustments.
After getting an IRS audit letter, how long do you have before the actual audit interview?
For IRS correspondence audits, taxpayers are generally notified within 7 months of filing. Once the letter is received, you generally have 30 days to respond, and the audit usually wraps up within three to six months. Office audits are usually initiated within a year of filing your tax return and are wrapped up in three to six months. Field audits are usually started within a year from when you file your return and often last about a year.
Does prep work for an IRS tax audit differ for businesses?
The only IRS audit prep work that differs for businesses is the type of documents that you will collect for the audit. For businesses, you need to keep detailed records of all income and expenses with dates and amounts and document the purpose behind your travel and entertainment expenses.
Documents you will want to have on hand for a business audit include all receipts organized by date with a note of what was purchased, bills with the type of service and date, canceled checks, any legal papers, loan agreements, logs or diaries, travel ticket stubs, medical & dental records, theft or loss records, employment records, and Schedule K-1’s, along with bank and financial statements.
Keeping records of your tax-related documents for two to six years is usually long enough to satisfy small business tax requirements.
How long after being audited will I get my refund?
Typically, after being audited, it takes around 6 to 8 weeks to receive an IRS audit refund check.
Does the IRS verify receipts during a tax audit?
Yes, the IRS does verify receipts during an audit to make sure that a receipt exists and to make sure that it is not a fake receipt. If they are questioning a specific expense, they want proof that the expense occurred. Be sure to have all receipts on hand during the audit.
What happens after an IRS audit?
If you have substantiated all of the items in question, the audit will be closed, and there will be no change to your tax return. If the IRS proposes a change to your tax return, you can agree, sign the examination report, and pay the additional tax. If you disagree, you can appeal the IRS’s decision either before the IRS or the tax courts.
An IRS audit doesn’t have to be an unpleasant experience. If you are always ready for an audit, whether you’re being audited or not, the process can be relatively painless. Always keep detailed, organized records of all business transactions so you have a clear paper trail for everything.
Caryl Ramsey has years of experience assisting in different aspects of bookkeeping, taxes, and customer service. She uses a variety of accounting software for setting up client information, reconciling accounts, coding expenses, running financial reports, and preparing tax returns. She is also experienced in setting up corporations with the State Corporation Commission and the IRS.
This article was fact-checked and verified by Katherine Varraveto, CPA.
Shoeboxed does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
Shoeboxed is a receipt scanning service that supports multiple methods for receipt capture: send, scan, upload, forward, and more!
You can stuff your receipts into one of our Magic Envelopes (prepaid postage within the US). Use our receipt app (iPhone, iPad and Android) to snap a picture while on the go. Auto-import receipts from Gmail. Or forward a receipt to your designated Shoeboxed email address.
Turn your receipts into data and deductibles with our expense reports that include IRS-accepted receipt images.
Join over 1 million businesses scanning & organizing receipts, creating expense reports and more—with Shoeboxed.
Try Shoeboxed today!