How Do Tax Audits Work?

A tax audit is a tax term referring to a type of formal examination or report. They often occur to overview and examine the finances or taxes of an individual, a household, or an organization. 

Sometimes, the Internal Revenue Service (IRS) will decide to examine someone's tax returns at random or when they find an error. This means they'll go back and look at the individuals past 3 returns to make sure everything is correct. They may also decide to perform this type of examination on a company or organization to check their returns for accuracy as well. 

It's a good idea to prepare now for potential auditing in the future. That way you will be more likely to avoid audits all together and be ready in case one does happen.

What is a Tax Audit? 

A tax audit is when the Internal Revenue Service (IRS) decides to review an individual's or organization's tax returns.

There may be varying purposes to a tax audit but for the most part, they verify the accuracy of an individual's or organization's reported income and deductions. These audits also help verify that individuals and organizations are compliant with tax laws and paid things like individual income tax.  

This helps make sure that the taxes owed are being paid and that no tax fraud is taking place.  

A tax audit can happen in 4 different ways: a correspondence audit, field audit, office audit, or through the Taxpayer Compliance Measurement Program (TCMP).  

What is a Correspondence Audit?

A correspondence audit is when the IRS sends you a correspondence letter through the mail to perform the tax audit.

First, the IRS will send you an IRS audit letter or notice with a request for additional information or clarification to fix your tax return. This request will also typically come with a 30-day deadline to respond.  

Then, you will send the letter back with whatever information or clarifications they have requested, and they will amend your return to be corrected.

This type of audit is typically for simple, minor errors, and easy fixes. The IRS may need a missing tax forms or may have noticed a simple math error that needs clarification or might need additional documentation like receipts or bank statements.  

What is a Field Audit?

A field audit is when an IRS representative visits your home or business to perform the tax audit.

First, the IRS will have an IRS Revenue Agent contact you to schedule a meeting at your home, your business, or your accountant's office.  

Then, you will schedule this in-person meeting with the tax agent and go over the review of your returns in person.  

This type of audit is typically to go over financial records like bank statements, receipts, and invoices, to make sure income and deductions and AGI calculations have been reported correctly. The agent may also need additional information or clarification about something on your previous returns. This audit could take anywhere between several hours and several days.  

What is an Office Audit?  

An office audit is when you visit an IRS office to meet with an IRS examiner to perform the tax audit.

First, the IRS will contact you to schedule an appointment at the IRS office. They may also ask you to bring specific documents or records with you to the appointment.  

Then, you will bring what the IRS asks for to your appointment and go over the review of your previous returns with an agent, at their office.  

This type of audit is typically less complex than a field audit. It may result in helping you correct an error on a previous return and signing an amended return.  

Taxpayer Compliance Measurement Program (TCMP)

The Taxpayer Compliance Measurement Program (TCMP) is when the IRS completes an audit on a high-income earner’s financial records to determine whether they reported all income and paid all taxes.

First, the IRS will schedule an in-person meeting with the taxpayer or the taxpayer's representation, like an IRS audit attorney. The examiner will then go over the review of the taxpayer's previous returns, income, tax deductions, tax exemptions, tax credits, etc. This review will go over the accuracy of everything reported and the agent may also request additional information or clarification to make sure everything is right.  

Then, you or your representation will also go over any additional information necessary or any clarifying questions to make sure everything reported is correct.  

This type of audit is not very typical and is reserved for taxpayers with certain criteria like income levels, business activities, or complex tax filing.

How a Tax Audit Works

An IRS tax audit is an examination of a taxpayer's financial records and tax information by the IRS or state taxing authorities. This examination makes sure that an individual, a business, or an organization is compliant with tax laws and regulations, that all the information on their returns is correct, and that all owed taxes have been paid.  

Step 1: You are selected for a tax audit

The process starts when a taxpayer is selected for a tax audit either randomly or when an issue comes up with a tax return.  

Step 2: You are notified of the tax audit

Then, the taxpayer is notified that they have been selected by the IRS or a state tax agency. This notification will include information like which tax years are being audited and the reasons they are being audited. Instructions for how the audit will proceed will also be available in the audit notice.  

Beware of tax scams with being notified by the IRS. The IRS will always contact you through the mail and not by telephone.

Step 3: The audit takes place

An audit can take place through the mail or in person.

If the audit takes place in person, then the examiner may ask to meet with you in your home, at your business, or at your accountant's office. You may also be asked to meet the examiner at their office.  

If the audit takes places through the mail, then you will simply send the information, clarification, or documentation requested to the address mentioned in your first notice.  

During the audit, the examiner will review the returns for the tax year's being audited. They might go over your income, deductions, credits you claimed (like the earned income tax credit, etc.), or other tax-related items.  

Step 4: The end of the audit

At the end of the audit, the examiner may have all their questions answered. If the tax auditor does find an error or discrepancy in the returns for that year, they may suggest amendments to that return.

You can then agree with those changes or appeal those changes. This amended return could lead to paying additional taxes and even sometimes paying interest and penalty fees. If you do appeal the changes, you could request a new examiner or a meeting with an IRS manager.

How Far Back Can an IRS Audit Go?

An IRS audit can go as far back as 6 years, but generally the IRS will audit up to 3 years back. Usually, they will only go as far back as 6 years if they found some significant errors. Otherwise, audits will only be for returns from the past 3 years.  

However, in the case of suspected fraud, if you never file your taxes, or other red flags, there is no time limit for how far back an audit can go.  

Do I Need an IRS Audit Attorney?  

Whether or not you need an IRS audit attorney depends on the specific circumstances of your situation. If you are facing an audit or owe back taxes that you cannot afford to pay, consulting with a tax attorney can be beneficial. A tax attorney can provide guidance on how to respond to the IRS, help you negotiate a payment plan or settlement, and represent you in court if necessary.

How to Avoid a Tax Audit

1. Keep detailed financial records for up to 3 years. Three years is the standard statute of limitations for the IRS to audit returns so long as those tax returns were filed on time.  

2. File on time each year. The 3-year statute of limitations doesn’t apply if you file late, so always file on time to avoid longer tax audits.

3. Explain anything you want to itemize on your return. If you want to include something as a business expense, include an explanation for that expense from the start.

4. Don't claim more deductions than you qualify for. Avoid claiming any deductions or credits if whether it really applies to you is questionable at all.  

5. Use a tax professional. While tax software can make tax filing easier, having an actual tax professional go over your taxes can reduce errors and missing items.  

6. File electronically. Avoid being audited due to bad handwriting by filing electronically instead of paper filing. If you're not tech-savvy, you can provide copies of the necessary documentation to a tax professional, and they file electronically on your behalf.