Thankfully, auditors don’t ever have time to examine every entry on a tax return. According to the IRS training manual, auditors are supposed to examine only significant items. Office audit notices typically list specific areas the IRS wants to examine—such as:
- Rental property income
- Interest expenses
- Dependents
- IRA rollovers
- Unreimbursed business expenses
- Charitable contributions
The IRS usually limits office examinations to no more than four categories.
Table of Contents
Who are your auditors?
The IRS tries to maintain a diverse workforce. Many auditors are young and they typically have little experience in the business world. Office auditors are usually not the cream of the IRS examination division.
When you are preparing for your audit, keep this in mind. If you are self-employed, be ready to describe how your enterprise functions as if you were teaching someone with no experience or background in the business world.
Top ten office audit issues
Take a look at your audit notice listing the issues the auditor will be concerned with in your audit. This section discusses the most common of those issues and provides tips on how to prepare for them. For office audits, you are required to prepare only for the listed issues. If an issue is listed on the audit notice that isn’t discussed below, you will need to do further research or contact a tax professional.
1. Income
The IRS says it loses far more tax dollars from unreported income than from overstated deductions. Auditors ask point blank, “Did you report all of your income?” Don’t take this question to mean the IRS has the goods on you—it is a standard question asked to everyone.
CAUTION:
Auditors have their antennae tuned for moonlighting jobs, homeowners renting out in-law units, folks who earn tips, and daycare–providing homemakers, among others. They are especially alert to certain occupations—like a handyperson or gardener—whose income is often not reported to the IRS on W-2 or 1099 forms.
TIP:
If the IRS is right, then don’t fight it. Acknowledge any unreported income for which the IRS has a correct W-2 or 1099.
However, if the IRS has erroneous data, show or offer to prove that it’s wrong. Ask for time to get a corrected W-2 or 1099.
Or, the problem may be a tax issue you can dispute.
EXAMPLE:
A bank wrote off a debt of yours for $15,000 and reported it to the IRS on a 1099. You didn’t list it on your return because you were insolvent at the time and the income wasn’t taxable. You can provide a statement of your assets and liabilities as of the date the debt was written off showing that you were insolvent—that is, your debts exceeded your assets.
2. Living expenses
If you reported income near poverty level, the auditor may want to know how you live. Office auditors seldom go into this, but field auditors routinely do it.
Be prepared to tell the auditor about your savings, relatives, disability payments, or other nontaxable sources of income.
3. Dependent exemptions
Be ready to show that you are entitled to claim everyone listed on your tax return as a dependent. For instance, if you support your elderly parents and claim them on your return, gather together documents showing you paid their expenses and their sources of income—such as Social Security.
You’ll have to prove that you provide more than 50% of their support. Whether or not you bring the documents to the audit is up to you. If the auditor requests documents, you can mail them in later.
Similarly, if you are a divorced parent who claims a dependent child, you probably need to provide proof that you are entitled to the exemption.
Proof may be canceled child support checks, a copy of your ex-spouse’s tax return showing that he or she didn’t claim the child as a dependent, or your divorce agreement stating who is entitled to the exemption.
4. Theft and casualty losses
If you claimed theft or casualty losses, be prepared to prove the deduction.
Provide a list of all of the items you lost plus other documentation of your losses. Good ways to prove losses are:
- Police reports
- Photos
- Purchase receipts
- Insurance claim forms
If you don’t have copies of these forms, contact the police department or insurance company for copies well in advance of your audit.
5. Charitable deductions
IRS regulations require that you document all donations of cash regardless of amount.
EXAMPLE:
If you dropped $40 into the collection plate every Sunday, you will have to provide more evidence than your own statement. Evidence might be a letter from your church secretary attesting to your regular attendance, combined with automatic teller withdrawal slips made on Sunday mornings.
In future years, consider writing a check each week.
To get a charitable deduction, the organization must qualify under Section 501(c)(3) of the tax code—the IRS has an online listing of all qualified charities and can look yours up if it has a question.
6. Unreimbursed employee business expenses
(Tax Return Schedule A)
If you are not self-employed, but on your job you spend money on for which you are not reimbursed and deduct that expense on your return, you’re an audit target. Auditors are especially suspicious of car, travel, entertainment, and home office costs of employees. Be sure to have a statement from your employer describing its reimbursement policy—or lack thereof. Bring pages in your calendar or business appointment book and attach receipts backing up the unreimbursed expenses.
7. Itemized deductions
(Tax Return Schedule A)
Unless you took the standard deduction, be ready to verify your itemized deductions on Schedule A. Some items are discussed above—such as theft and casualty losses and charitable contributions. Others are your home mortgage interest, points paid for the purchase, real estate taxes, your motor vehicle registration, your medical deductions, and a few other items.
EXAMPLE:
If you bought a house and the seller is carrying your mortgage note, you will need a statement from the seller or escrow company and your canceled checks. Points are shown on the lender’s statement or escrow papers, but are deductible in full only for the original mortgage, not for any subsequent refinancing.
If you don’t have a copy of the vehicle registration showing the deductible amount, contact the motor vehicle office before the audit and ask for a copy.
TIP:
For all expenses, get copies of bills, canceled checks, credit card slips, and any other documents you can think of that support your claims.
For the second part of this article preparing for an office audit, click here.