We call them audits; the IRS prefers examinations. Whatever term you use, it describes one of life’s most dreaded experiences—the IRS probing into your financial affairs.
This chapter deals with the types of IRS audits—both correspondence and face-to-face—that individuals and small business owners are most likely to face. The IRS also has a Large and Mid-Sized Business Division for auditing corporations with assets over $5 million, as well as a Tax-Exempt and Government Entities Division.
Table of Contents
Introduction
The vast majority of tax returns are accepted by the IRS without question. Your chance of being contacted by the IRS about a discrepancy on your return in any one year is only one in a hundred. But if you are self-employed, the odds of at least one IRS examination in your taxpaying lifetime are closer to 50%. These are the cases where IRS defense becomes relevant.
Important Considerations
As your income increases, so does your audit likelihood. If you regularly earn over $100,000 per year, your probability of an audit has increased every year over the past decade. And when your time does come, expect it to cost you—five out of seven people who are audited owe additional taxes. A few people get tax refunds after an audit, but don’t count on it. The amount of money the IRS assesses in audits is 32 times greater than the amount given back.
Federal courts have long held that if the IRS determines at an audit that you owe taxes, there is a rebuttable presumption that the determination is correct. This means that you have the burden of proof when up against the IRS. Critics have said that it really means you are guilty until proven innocent.
While this is the standard in audits, it is not the standard in court proceedings where the IRS has the burden of proof. If you take the IRS to court, the government must show that you were wrong on a disputed factual issue, not vice versa. See Going to Tax Court
Don’t File a Tax Return During an Audit
Never file a tax return while an audit is in progress, even if asked to do so by an auditor. You risk having the audit expanded to include that return. Instead, file an application for an extension until October 15.
If the audit is still alive on October 15, consider not filing until it is completed. If you’ve paid all taxes due, you won’t incur any penalties or interest for not meeting the filing deadline. If you owe additional money, send in your payment with a letter stating that the payment is to be applied to that year’s tax return.
If you didn’t read this in time and have already filed a return during an audit, politely refuse to give a copy to the auditor if she asks.
How Long Do I Have to Worry About an Audit?
Generally, your tax return cannot be audited after three years from its original filing date. If you filed before the due date, April 15, the three years start running from April 15 of the year it was due.
There are a few exceptions, however:
- If you understated 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 evident.
- The audit time limit period, called a statute of limitations, starts to run only if and when you file a tax return. Unfiled tax years are always open to audit. If, however, you haven’t filed and haven’t heard from the IRS within six years of the due date of a tax return, you have probably escaped the audit net.
Tip
Audit notices are usually mailed between 12 and 18 months after you file your 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 contact.
The Internal Revenue Manual directs auditors to complete audits within 28 months after you file your tax return. Legally, the IRS has 36 months. The 28-month internal deadline is imposed, however, to allow eight additional months for the IRS to process any appeal you might request.
Read More: Winning Your Audit: an In-Depth Guide
These internal IRS time limits usually work to your benefit. Audit cases are often delayed within the IRS for various reasons—backlogs, agent transfers, postponements, complex issues, and lost files. The older your file gets, the more anxious the IRS is to close it. Auditors can be fired for missing the 36-month deadline, known as blowing the statute, but it still happens.
Stopping an audit once it begins. Once the IRS sends an examination notice to your last known address, the audit has begun. It is difficult to stop an audit. Even if you die, your spouse or the executor of your estate is obligated to carry on the audit.
You may be able to slow down—or even stop—an audit, however, if you ask for a transfer of your file to another IRS district. Audit transfers are discretionary with the IRS, and you need a good reason to get one—such as a more convenient location of your tax documents.
Example:
Janiel, who lived in Pennsylvania but had a jewelry business in New York, received an audit notice for Pennsylvania. She requested a transfer to where her business was located. Janiel told the IRS that her records were at the business location in New York, which was true. The transfer was granted, but the New York office’s audit plate was already full and the office never got around to Janiel’s audit. The three-year statute of limitations expired and Janiel’s worries came to an end.
Will the auditor discover the money I made from playing the organ at weddings?
I lost my records in a move last year—what am I going to do?
Was I entitled to claim my mother as an exemption?
Will the IRS question my home office deductions?
Is the IRS going to put me in jail if they find out I’ve been cheating?
These are common taxpayer concerns. So, let’s look at what really goes on when the IRS decides to audit you. We’ll look at the two primary issues in every audit:
- Did you report all income?
- Were you entitled to the deductions, exemptions, and credits claimed?
IRS Publication 17, Your Federal Income Tax, explains the audit process—from the IRS point of view.
The Audit Burden Is on You, Not the IRS
An audit is the process by which the IRS determines whether you properly reported all income—from earnings and investments—and took the correct deductions, exemptions, and credits. If the IRS finds that you didn’t, you will be assessed additional taxes, interest, and—usually—penalties. An assessment is the formal entry of a tax liability in your records.
To do its job, Congress has given the IRS wide powers to inspect your financial records and to ask you and others about your financial affairs, to determine whether you are cheating Uncle Sam. (Internal Revenue Code §§ 7601 and 7602.) The IRS will investigate the items listed on an audit notice checklist given to you and scrutinize any other areas deemed questionable. And the law specifically places the audit burden on you to demonstrate that the information shown on your tax return is correct—think of the IRS as the Show-Me state of Missouri. If your dispute gets to court, however, the burden shifts to the IRS under certain conditions.
Note: A tax attorney isn’t required to take on the IRS, though it is recommended in most cases. For more information, see Going to Tax Court.
Proving the correctness of your tax return may not be that easy. The IRS wins over 80% of all audits, mostly because taxpayers can’t properly verify the information on their tax returns. IRS auditors say that the biggest reason for adjustments is poor recordkeeping, not taxpayer dishonesty.
Do I Have to Learn Tax Law to Win My Audit?
To understand the audit process, start with the Internal Revenue Code, or tax code. The tax code contains 8,500-plus pages of very fine print. Add to that IRS regulations, revenue rulings, letter rulings, manuals, and official publications, all of which add another 100,000 or so pages of tax law. Finally, there are thousands of court decisions telling us how tax laws should be applied in individual cases. The total number of tax law pages exceeds one million!
How will I ever understand the tax laws?
You won’t. But that may not be as much of a disadvantage as you might think. Tax law is so voluminous and complex, most IRS auditors don’t know it well either. Moreover, the training and experience level of IRS personnel is declining while the law is getting more difficult to master. This means that auditors normally stick to predictable audit issues. A taxpayer with very high income or an intricate tax issue, however, may be assigned an auditor with more training and experience. But normally, if you are well prepared, you will come out okay—experiencing the minimum damage—most of the time.
In a few hours, you can learn the basic tax law for your particular audit issues. The information is in this book and other sources mentioned in this article. And you can—and probably should—consult with a tax professional before taking on the auditor.
The truth is that most people succeed in an audit without knowing any tax law at all. This is because many audit issues are factual, not legal. The distinction will become clear as you read this chapter. And it’s as important to know IRS procedures—the rules of the game and your rights in dealing with the IRS—as tax law. This book explains the rules to follow and psychology for dealing with the IRS as well.
Continue to part 2