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What You Should Know About IRS Audits

March 23, 2016
Income Taxes, Taxes
What You Should Know About IRS Audits
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Once you’ve filed your return to the IRS, you’re finished with your taxes for the year — at least that’s the hope. But if the IRS has questions about your filing, your return could be flagged for an audit.

The prospect of an audit can be frightening, but the reality is that the IRS audits around 1% or fewer of taxpayers each year. Due in part to its shrinking budget, the IRS reports it audited 1.2 million returns in fiscal year 2014 — about 12% fewer audits than in the previous year and the lowest number since 2005. 

It’s unlikely that you’ll be audited, but if you are, it’s a big deal. Here’s what you need to know about how the IRS decides to audit you and what to do if it does.

Your chance of an audit

It’s tempting to think only your current year’s return can be audited, but the IRS can audit your past three years of returns. If returns look especially suspicious, the agency could go back as far as six years.

The IRS uses the Discriminant Information Function system to determine which returns get audit-level attention. This system compares your return with others filed by people with similar professions and incomes and assigns it a DIF score. If the financial information in your return varies significantly from the information provided by your peers, your return gets a high DIF score, which increases the chances you’ll be audited.

The DIF is more likely to trigger audits on the returns of high-income earners. Because the IRS has endured budget cuts over the past few years, it must focus its resources where it gets the most lucrative results. But while the returns reporting high income levels incur the greatest percentage of audits, taxpayers with more modest means still see their fair share.

Here’s how the audit numbers shake out, according to the Internal Revenue Service Data Book, 2014:

Adjusted gross incomePercentage of returns filedPercentage of returns audited
$1 – $24,99939.080.93

The audit process

If the IRS decides to audit you, it will notify you by letter or telephone. The agency will never contact you by email.

While an IRS audit is certainly not a welcome outcome for any taxpayer, the reality may be less dramatic than most taxpayers imagine. Many audits consist of only a letter from the IRS, asking the taxpayer for verification or correction of specific information. This is called a correspondence audit. If you’ve made a math error on your return, you’ll have to pay any additional tax you owe. That’s it. Case closed.

But if the IRS has serious questions about your return, you’ll get a request for a more daunting in-person audit. An in-person audit can be triggered by relatively minor issues that are easy to resolve, but reporting all of your income and following the rules around deductions and credits is the best way to avoid an audit altogether.

Either way, an audit is a serious matter. If you are audited, consider consulting a tax professional. Some online tax programs offer an audit-protection service to help you navigate the process. If you prepared your taxes without audit protection, it’s a good idea to hire a tax attorney or an accountant to represent you to the IRS. 

Using tax software or hiring a pro doesn’t necessarily reduce your chances of an audit. Either of these options likely reduces your chance of filing a return with math errors, but the accuracy of deduction and credit information falls on you.

Your legal rights

If you receive an audit notice, you should know your rights. These include:

  • Your right to professional and courteous treatment by IRS employees.
  • Your right to privacy regarding your tax matters.
  • Your right to know why the IRS is asking for information, the purpose of the information and the consequences of not providing the information.
  • Your right to representation.
  • Your right to appeal disagreements within the IRS and before the courts.

The IRS lays out details about your rights during an audit in Publication 1, Your Rights as a Taxpayer.

Audit outcomes

Your IRS audit will conclude in one of three ways. If the agency determines that your return is accurate, you won’t need to make any changes. If it determines that your review is inaccurate, you can either agree with the changes and pay any resulting back taxes or penalties, or you can disagree and pursue the process legally. 

If you haven’t already hired an attorney or an accountant, an audit appeal is a great time to do so. A tax professional who understands how the IRS works can bring about a better outcome than you can as an outsider operating on a high-emotion curve.

Image via iStock.