Audits can be a nerve racking experience. Many times they feel like an investigation, and the outcome is often painful. This is especially true when the audit involves the Internal Revenue Service.
Tax Audits
In this article, we're hoping to relieve some of the anxiety around the prospects of getting audited by the IRS. We'll start by providing some facts on the odds of being audited. Then we're going to talk about the three types of audits the IRS conducts. Finally, we'll provide hints on how to avoid an audit in the first place, as well as some tips on dealing with auditors.
Odds of Being Audited
The overall risk of being audited is very low, and the risk of being involved in a face-to-face review is even lower. When the IRS targets an individual, they are usually only interested in learning more about one or two elements of their filing, not the entire tax return.
In 2006 the IRS conducted approximately 1,300,000 audits. To put that number in perspective, there were roughly 132 million tax returns filed in that year. That means the odds of being audited were less than 1%, or 1 in 100.
Taxpayers making less than $100,000 have an even lower chance of being audited. In fact, the rate for this group was only 0.89%, or roughly 1 in 110.
Taxpayers making more than $100,000, but less than $1,000,000, were audited at a rate of 1.67%, or 1 in 60.
Taxpayers making more than $1,000,000 have around a 6% chance of being audited, which are roughly 1 in 17 tax returns.
As the above numbers demonstrate, the risk of being audited increases with income level. This happens for two reasons:
The first has to do with the complexity of the return. Upper income individuals and families usually file more complex tax returns, so it's easier to make a mistake.
The IRS uses complex computer models to maximize their chance of recovering money during an audit. Tax returns involving higher levels of income automatically increase the odds of the IRS recovering more money.
In 2019, the IRS audited 771,095 individuals, covering 0.45 of all tax returns filed. Audits of individuals in the upper income ranges remain substantially higher than the overall average.
Three Types of Tax Audits
Even if someone is audited by the IRS, that doesn't mean they're going to have an agent visit their home. There are three types of audits the IRS conducts, each with increasing levels of complexity:
Automated Inquiries
Correspondence Audits
Field Audits
Automated Inquiries
An automated inquiry really isn't even an audit. It's basically a discrepancy the IRS found between the tax return and the information received from another party such as an employer or bank. This type of audit usually happens within months of filing a return. Many times, a discrepancy inquiry will be settled by appeal or payment of additional taxes owed.
Correspondence Audits
Approximately 76% of all audits conducted by the IRS are correspondence audits. For taxpayers making over a million dollars a year, nearly 60% of audits fell into this category. This means only 3.4% of these taxpayers were subjected to a field audit. As the name implies, a correspondence audit involves a letter from the IRS, usually disputing two or more elements of a tax return that do not appear to be correct.
Correspondence reviews usually require the taxpayer to submit additional documentation to clarify what appears on the tax return. Once those documents have been reviewed by the IRS, the agency will issue a proposed amendment to the tax return. As is the case with an inquiry, the judgment resulting from a correspondence audit can be appealed.
Field or Desk Audits
The most thorough type of audit the IRS conducts is a field or desk audit. This process involves a face-to-face meeting with an IRS agent, and the review of one or more tax returns. Unlike an inquiry, a sit-down audit may take place several years after filing a return.
Avoiding a Tax Audit
With 253 million tax returns (2019 data) to sift through, the IRS relies on automation to raise a "red flag" when something on a tax return looks suspicious. Almost all the precautions a taxpayer can take involve the proper reporting of income and deductions on a return.
Properly Reporting Sources of Income
There are two important factors to keep in mind when it comes to reporting income on a return:
Reporting Income on the Proper Tax Form: this includes reporting W-2 information on line 7 of Form 1040, as well as reporting non-employee compensation (1099-MISC) on Schedule C.
Ensuring the Income Reported is Correct: this includes information on the W-2, as well as making sure the proper Social Security number is associated with the income that individual generated. This also includes making sure tips and cash payments that serve as income are not under-reported.
Individuals have several options if they're not sure where to report certain sources of income. This includes the instructions appearing on the tax forms themselves, automated telephone instructions, as well as help available from local offices of the IRS.
Documenting Deductions
When it comes to tax deductions, the key to staying out of trouble with the IRS is to keep detailed records. A tax deduction that might be viewed as unusually high relative to prior returns can be substantiated by attaching information. If complex calculations are involved, then attach that documentation too.
Above all, follow the directions found on the IRS tax forms. For example, one of the more common mistakes is taking the same deduction twice, including taking the deduction in multiple places such as Schedules A, C, and E. Another common error is rounding to the nearest ten dollars or hundreds of dollars instead of rounding to the nearest dollar.
Dealing with an Auditor
If a professional service was used to help prepare a tax return, that service provider will usually help during an audit. That same provider may also charge a fee for this service, unless the audit itself was a direct result of a mistake made by the tax return professional.
Many of today's tax preparation software providers offer some form of an audit insurance policy. For example, H&R Block provides a free service with its TaxCut software package called WorryFree Audit Support, while Intuit's TurboTax provides a service called Audit Defense for a fee.
Taxpayers preparing their own return always have the option of representing themselves during an audit. Alternatively, they can hire a CPA, an attorney, or a licensed tax preparer to help. The decision to hire a professional usually depends on the number and complexity of the audit findings themselves, as well as the person's ability to deal with the stress of meeting with an agent from the IRS.
Additional Resources
- Online publications typically circulate their tax planning tips at the end of the year. But tax planning can take place all year long; it doesn't matter whether the April filing deadline is 12 months away or just around the corner.
Moneyzine EditorOctober 4th, 2023 - Whether it's the start of a new year, or the April filing deadline, there's usually something that can be done to reduce a tax bill. When it comes to taxes, having a plan can help maximize savings on a return.Moneyzine EditorOctober 4th, 2023
Every year, taxpayers go through the ritual of gathering the information needed to file their federal income tax return. Once completed, those records are often filed with those of prior years.Moneyzine EditorNovember 21st, 2023
Each year, the Internal Revenue Service (IRS) releases their latest statistics on the billions of dollars it has in unclaimed tax refunds. The most common cause of a refund going unclaimed is failure to file a tax return. But there are also undeliverable refunds attributed to bad mailing addresses too.Moneyzine EditorDecember 5th, 2023- The objective of a federal income tax return is to calculate taxable income. While completing IRS Form 1040 may seem complex at times, the entire process can be broken down into two parts: identifying all sources of taxable income, as well as expenses that can be deducted from income.Moneyzine EditorDecember 5th, 2023
