Getting a letter from the IRS letting you know you’re the “lucky” recipient of a tax audit creates instant dread and panic. It’s the news no one wants to receive because it could mean more costs and even penalties. Yet, there’s a slight chance you could get a bigger refund, too.
The IRS says it conducted more than half a million tax return audits in 2020. That made people and businesses pay an additional collective $12.9 billion in taxes. The reality is that a tax audit could happen and it may not be all bad.
1. Familiarize yourself with possible audit triggers
Any correspondence you receive from the IRS may include a reason for the audit and highlight the trigger for you. However, the agency may actually not share that information or have multiple reasons for the audit. Therefore, be aware of these potential triggers so you can address these during the process:
- Your income is exceptionally high or low: There could be a simple explanation for this (you’re a freelancer with varying income, for example). But, it may still be a trigger.
- You didn’t report all income: You left out income that you received. Perhaps you didn’t get a 1099 form for it or your employer/clients reported they paid you a specific amount but you failed to include it.
- You claim home office expenses: The IRS wants to make sure you truly use space in your home for business and may question the square footage and claimed deductions.
- You have international assets: The IRS may think you could be hiding some of your income in offshore accounts or not reporting income from international clients.
- You operate a cash business: Income is difficult to track so the IRS wants to make sure it’s getting their fair share.
- You use your car for business: Like your home office expenses, this type of deduction is carefully watched to ensure it is legitimate.
- You file an Earned Income Tax Credit (EITC): This is a tax credit that increases based on the number of dependents you claim. If you file for this credit, then the IRS wants to make sure you actually qualify.
- You made a withdrawal from a retirement account and didn’t account for it on your taxes: Your plan administrator will report a withdrawal so not accounting for it makes you an easy audit target.
- You don’t report gambling winnings: Similar to a retirement withdrawal, the IRS receives information on gambling winnings from a casino or other organizations.
- You claim losses for your hobby or rental business: Both of these types of businesses often make income or, at the very least, operate on a low overhead, so any reported losses get questioned.
- You made math errors on your tax return: Any mistakes made in how you added up figures listed on your return draws more attention from the IRS.
- You have exceptionally high business expenses/deductions: If your expenses seem high for the amount of income you’ve earned, then it becomes an audit trigger.
- The IRS computer system and its algorithm selected you: “Winning” the audit lottery typically happens when the system detects anomalies in the data they analyze on your current and previous tax returns. It may involve one or more triggers on this list or anything else that stands out.
2. Contact your tax professional for advice and assistance
The next step is to contact your accountant, bookkeeper, or any other tax professional you use for filing your taxes. Even if you self-prepare your taxes, it’s still recommended that you seek professional help.
In some cases, you can pay your tax professional to oversee or participate in the audit with you. Or, you can stay in contact throughout the audit process to get advice.
Share all the correspondence you’ve received, including information on the audit time and location. Some audits involve correspondence while others require you to go to an IRS office. They may even come to you. The professional can help by directing how you prepare for any scenario.
Find out: How to Choose the Best Tax Software for You
3. Get your financial records in order, including all receipts and documentation
Being ready to share as much information as possible can make the process easier. This information should include all financial records, including bank statements, financial statements from any accounting software you use, expenses, retirement accounts, and credit card records. If any records are lost or have been destroyed, take the time to request statements and information from vendors or companies that may still have what you need in their files.
Be sure to keep personal expenses separate from business records. Also, if you’re being audited because you reported years of business losses, you may need to prove how you tried to make a profit by supplying marketing or sales expenses from those years.
4. Know your rights
You can opt to do the audit alone or you can send a representative in your place. Approved representatives include a Certified Public Accountant, tax lawyer or IRS enrolled agent.
You or your representative should only provide requested documents. You can also expect confidentiality and privacy for your tax and audit information, and courteous treatment from IRS staff. The agency must also tell you the reasons for the audit and any penalties for non-compliance.
5. Understand what steps you can take if you don’t agree with the audit report
You have the right to contest the audit report with the IRS and in court. If the results of the audit are not in your favor, you can refuse to sign the report.
From there, you can request that an IRS supervisor review the agent’s findings as well as seek assistance from the Taxpayers Advocate Service. You can also go to the tax court to see if you can overturn the audit report.
Of course, you can also prepare to pay the amount listed in the audit, which often includes interest and penalties on top of the extra tax. For that, you can request a payment extension through an installment payment plan. Tax debt relief options are also available.
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