Few things in life are as universally dreaded or feared as an Internal Revenue Service audit. For many Americans, the calculator-wielding IRS agent has become the adult equivalent of the childhood monster lurking under the bed. IRS auditors usually don’t have quite so frightful an appearance but they make up for that fact by actually being real.

Why are IRS audits perceived so negatively? Though not all audits end up costing the taxpayer money even the best-case scenarios end up requiring your time and the hassle of paperwork. On the other hand, the worst-case scenario involves not only money, but criminal charges and possible jail time. IRS audits are by no means new; however, they are a growing problem for many taxpayers. The IRS has stepped up auditing efforts in recent years in part to offset the increased government spending over the past decade. 

With the increase in IRS tax audits it is more important than ever to know how to deal with them. In this guide, we’ll look at the details of what a tax audit is, how to reduce your chances of being audited and what actions to take if you are faced with an audit.

A tax audit is a process the IRS uses to determine whether an individual or business has paid the correct amount of income taxes. Technically, an audit can end up finding that someone has paid too much in income taxes in which case the IRS would end up owing the taxpayer money. This is exceedingly rare, though, as it is the opposite of the Internal Revenue Service’s goal to increase revenue. Therefore, the IRS focuses on auditing only those tax returns where there is a fairly good chance that the taxpayer will end up owing more money.

To determine whether more taxes are owed an audit looks at whether the information and calculations on a tax return are correct. This generally means making sure that all income is correctly reported, and that all the deductions claimed are real and valid. Usually, IRS auditors will require written proof to back up the claims made on the tax returns.

How the IRS Chooses Which Returns to Audit

Most tax returns are not audited. In fact, some people can go their entire lives without having a single tax return audited. However, the IRS still audits somewhere between 1 and 2 million individuals each year. And those people are not chosen randomly. As mentioned, the real goal of IRS audits is to increase the amount of taxes collected. If an audit is not likely to result in more taxes being collected then it is not worth the IRS agent’s time and it would not be worthwhile for the IRS to pay auditor’s salaries.

There are several methods the IRS uses to decide which tax returns should be audited:

• Computer analysis. The IRS has completed many millions of tax audits over the years. With modern computing power they are able to analyze past audit results to identify patterns, trends or common features of the tax returns that tend to be worth auditing. A specialized computer program called the Discriminate Function System uses that data to analyze every new tax return. The Discriminate Function System gives each return a numerical rating, called a "DIF score". The higher the DIF score the more likely it is that an audit would be profitable for the IRS and the more likely it is that the return will be audited.
• Tips and referrals. The IRS sometimes receives tips from people who suspect that someone they know is underpaying on taxes. Likewise, IRS auditors themselves will sometimes refer other people for auditing. In examining paperwork for one audit they will sometimes uncover information to suggest that some related person or business should also be audited.
• Reporting institutions. Employers, banks and investment institutions are usually required to report money paid to or earned by their employees and clients. If they report something that is different from what is on the individual’s tax return the tax return is likely to be audited.

Not all audits are handled the same way. For the most part IRS audits can be classified in three broad categories:

• Correspondence audits. In some audit cases the IRS agent and the taxpayer never see each other face-to-face. Instead, the audit is performed through the mail or by phone. The auditor may request specific paperwork through the mail, or call the taxpayer to answer questions about the return. This type of audit is used for the simplest cases.
• Office audits. The next step up in audit complexity is the office audit. Office audits are held at an IRS Area Office and may require the taxpayer (or a representative) to meet with the IRS agent at the IRS agent’s office. This type of audit is commonly used for businesses and more complex tax returns.
• Field audits. This is the most involved type of audit in which the IRS agent goes “out into the field” and actually comes to your home or place of business. Besides being more detailed and more intrusive field audits are also handled by more experienced, better-trained IRS revenue agents. The revenue agents will sometimes also bring along specialists who are experts in specific technical details.

In all three types of audits the primary goal for the IRS is a financial one: ensuring they have collected the full amount that should have been owed in taxes. With all the complexities of the tax code most mistakes uncovered by audits are exactly that: mistakes. Honest mistakes can certainly cost you money in an audit; you can end up with an additional tax bill and financial penalties will often be assessed on top of what you owe.

However, an audit can also uncover evidence of tax fraud. Tax fraud is when someone intentionally falsifies their tax return in order to lower their tax bill or avoid paying taxes. If the auditor finds evidence of fraud then the audit becomes a criminal investigation.

With a criminal investigation the IRS agent is required to turn the audit over to the agency’s Criminal Investigation Division. At this point it becomes much like the investigation of any other crime. Some form of law enforcement officer, or “special agent,” will become involved and you will have similar rights as you would in a police investigation (such as the right to remain silent). Criminal investigations can result in large financial penalties and up to five years in prison.

How the IRS Gathers Information

The audit process is largely about the IRS gathering information and how that information is interpreted. If you are being audited you will almost certainly be asked to provide information, usually in the form of written records, to support or clarify the claims made on your tax return.

The written records an auditor may ask for include:

• Receipts, to provide proof for purchases that are claimed as tax deductions.
• Invoices for work that you paid for, or that somebody paid you for.
• Accounting ledgers for your business.
• Tax returns for years other than the one being audited or from other people or businesses related to the tax return in question.

The IRS agent may simply ask for the information or issue an IRS Information Document Request Form. If the person being audited does not then hand over the requested information the agent may issue an administrative summons. An administrative summons, often simply referred to as a “summons”, is a legal order to provide the requested information on a certain day, at a specified time and place. Failure to comply with a summons is a crime punishable by a fine and/or jail time.

Besides collecting information from the person or business being audited the IRS can also request (or summons) information from other people or businesses who are not being audited but who may have paperwork or other information relevant to the case. If the IRS agent does issue a summons to a third party they are required to also notify the person being audited that the summons has been issued.

Audit Rulings and Appeals

After finishing the audit the IRS agent will make a ruling. In some cases the ruling may be that there is nothing wrong with the original tax return and that nothing needs to be changed. If the agent decides that the tax return does need to be adjusted they will fill out a form or write a report detailing what changes need to be made and how much additional taxes or penalties are owed.

• If the taxpayer agrees with the agent’s ruling then the audit is considered an “agreed case.” They will both sign off on the agreement and the taxpayer will be responsible for paying any agreed upon taxes and penalties.
• If the taxpayer does not agree with the agent’s conclusions then the audit is an “unagreed case.” The agent’s report will then go to an IRS audit manager who will decide whether to approve the agent’s recommendations. If approved by the manager the audit report will be enforced and the taxpayer will be required to pay the amount determined by the audit.

In such “unagreed” cases the taxpayer will receive a “30-day letter” which explains that they have 30 days to either pay up or appeal the decision. To appeal the taxpayer must present a written protest to an IRS appeals officer. The appeals officer then has three options when reviewing a protest:

• Agree with the audit report and require the taxpayer to pay the stated amount.
• Agree with the written protest. In this case, the taxpayer wins the appeal and does not have to pay the disputed taxes and penalties.
• Negotiate with the taxpayer to reach a compromise or settlement. The taxpayer will still have to pay the negotiated amount but it will be less than the audit report had claimed.

If the taxpayer’s protest is unsuccessful they still have another chance to appeal. Within 90 days of the ruling the taxpayer can petition the Tax Court in an effort to have the tax bill recalculated. If that appeal fails the IRS will issue a bill for the amount owed. The taxpayer will then have to pay the bill in full by the due date. Failure to pay the bill will result in the case being transferred to the IRS collections department.

“An ounce of prevention is worth a pound of cure.” That old proverb is particularly applicable to IRS tax audits because even audits that end up ruling in your favor can still cost you time and cause unnecessary stress. It is possible to reduce your odds of being audited but only if you know what the IRS is looking for and what factors can trigger an audit.

Common Audit Triggers

You may recall that most audits are initiated by a computer program that scores tax returns based on a number of factors. Though the exact formulas used to calculate these DIF scores are known only to IRS computer programmers experience shows us which factors tend to make an IRS audit much more likely.

• Data entry errors. An audit can be triggered by something as simple as entering your social security number incorrectly or misspelling your own name. Making math errors is another trigger.
• Unreported income. The IRS receives copies of the same income reporting forms you do and compares your income from year to year. A noticeable discrepancy can look suspicious.
• Overstating deductions. Always submit receipts of your charitable donations and report accurately.
• Claiming non-existent dependents. Follow the IRS guidelines for deciding whether someone is your dependent, and be truthful.
• Self-employment. Especially if you fail to report a profit for at least three out of five years, the IRS may think you are using this status as a tax dodge. 

Reducing Your Odds of Being Audited

With those audit triggers in mind, here are some things you can do to help prevent the IRS from pulling that trigger.

• Incorporate your business. If it is large enough to justify incorporation doing so will allow you to skip those troublesome Schedule C forms.
• Don’t overestimate deductions. Sure, you want to claim valid deductions to lower your tax bill but be careful—and realistic. For those non-cash donations to charity use IRS Form 8283 and claim only what the item is really worth. For travel and entertainment expenses only claim what you can clearly support as being necessary for business.
• Collect wages from your S corporation. The IRS is looking for you to be paid a “fair” wage for the work you do.
• Report all income, interest and investment tax forms you receive.
• Check your calculations. Math mistakes draw unwanted attention to your tax return.
• Do not brag about saving money on income taxes. Remember that some people tip off the IRS about people they think should be audited and can sometimes receive rewards for doing so.
• Hire a professional. A tax preparation professional will know everything that should or should not be included on your tax return. They can provide expert advice on how to best reduce the odds of an audit on your particular return and eliminate any potentially costly errors.

Handling a tax audit can be tricky. The auditors at the IRS are highly-trained, experienced specialists; auditing is their full-time job. While “tax season” might be limited to the time before April 15 each year “audit season” is year-round and is what auditing agents do every day. Some of the procedures and methods used by auditors are specifically designed to take advantage of taxpayers who are unfamiliar with the audit process, encouraging people to inadvertently provide incriminating information against themselves.

Perhaps the most important thing to remember about IRS audits is that you always have a right to professional representation; you never have to face an auditor alone. In fact, ask any impartial expert and they will always recommend having a professional on your side to guide you through the audit process. If you do choose to deal with an IRS audit on your own, though, here are some tips that can help you come through the process relatively unscathed.

Tips For Handling An IRS Audit

• The right to have professional representation. If you agree to meet with the IRS agent alone and during the meeting decide that you do want representation after all the agent is required to stop the interview until you can find such representation.
• The right to have any meeting with the IRS take place at a reasonable and convenient time and place.
• The right to refuse meeting with an IRS agent at all unless ordered to do so by summons.
• Notification if any information is summoned from a third party with enough time provided to challenge the summons if needed.
• Protection against double jeopardy. If the IRS has already audited your tax return for a certain year and found no problems with it, they are not supposed to audit it again (unless the audit is for items that were not looked at the first time).
• A right to professional and courteous service from IRS employees.
• The right to record any meetings with the auditor.
• The right to an appeal.

Respond on time. When you receive an audit notice you do need to respond within the time period allotted. Otherwise, the IRS may issue a legally enforceable summons or simply rule against you. But, at the same time…

Don’t be in a rush. There is a statute of limitations on collecting money via an audit so time may be on your side. In most cases, the statute of limitation is three years after the tax return deadline (or after the tax return was submitted to the IRS if it was turned in late). In some more serious cases, the statute of limitations is extended to six years.

Be nice. Being rude to the auditor or unnecessarily making their job harder will not inspire them to give you the benefit of the doubt. However…

Provide only the information requested. Being nice to the IRS agent does not mean that you are on their side. If you provide additional documents that the agent has not officially requested, the information on those documents can be used to investigate other aspects of your taxes and look for discrepancies that were not part of the audit’s original scope.

• This tip also applies to answering questions; IRS agents are trained to ask open-ended questions in the hope that the taxpayer may accidentally reveal incriminating information by simply talking too much.
• In some cases, the requested documentation may contain additional information that you do not want the IRS to see. For example, an invoice used to prove payment may contain a description of services rendered that could be damaging to your case or your company’s books may include confidential information about a client or supplier. In such cases, you can offer to provide a different proof of payment— such as a canceled check— or redact any confidential information on the documents.
• You can decline to provide requested information unless (or until) a summons is issued.

Keep a record of all information requested, and all information provided. Only give the IRS copies of records and keep the originals yourself.

When possible, hold meetings at the IRS office not your office. That way you can bring along only the records that have been requested and the IRS agent will not have access to the other records kept in your office or home.

If the audit starts to turn into a criminal investigation, stop and get help. The tip about “being nice” will not help you avoid any criminal penalties. Do not treat a criminal investigation like it is a mere audit. Treat it for what it is: a criminal investigation that can turn into a trial and could result in jail time. There are several things you can look for that usually indicate the audit is heading toward a criminal investigation:

• The IRS agent starts asking about your motives with questions such as “Why did you do that?” or “Didn’t you know?”
• The agent suddenly and unexpectedly stops communicating with you.
• The agent issues a summons for documents that are not part of the year being examined.
• A “special agent” or law enforcement officer becomes involved.

As you can tell IRS tax audits are not to be taken lightly. They can literally lead to a situation where you are facing six-figure fines and multiple years in prison if found guilty of tax fraud. Though very few cases are that severe, it is quite typical for IRS audits to result in you owing more money in taxes—sometimes much more. Almost by definition, such audit corrections will also result in financial penalties for underpayment, late payment and inaccuracies or negligence in preparing the tax return. And since these bills are unexpected additions to the taxes you have already paid, people sometimes find themselves unable to pay such expenses in which case the IRS collections process can seize whatever assets you own.

Because of these consequences it is never advisable to go into a tax audit alone. By hiring professional representation you can ensure the best possible financial outcome from the audit, while minimizing your effort, time and stress.

A tax resolution professional brings multiple benefits to the audit table, including:

• Expert knowledge of the whole process.
• Experience in dealing with IRS agents and an understanding of their strategies and tricks.
• A clear head during meetings with auditors without the nervousness or anger that can come from being the person under audit.
• Advice on what steps to take, what information to provide (or withhold) and what items to challenge or dispute.
• The ability and time to focus on the details of the audit while you get on with your own business.
• Legal representation during the appeals process or in a criminal investigation.

At Top Tax Defenders, preventing and resolving issues with the IRS is what we do. We are the experts on your side to face off against the experts at the IRS.

We offer a multitude of services to get you out of your audit mess, such as:

• Audit representation
• Help dealing with IRS revenue officers or agents
• Tax preparation help to reduce your odds of being audited
• Assistance in settling any taxes or penalties that result from an audit
• Negotiating with the IRS to reduce the amount owed
• Criminal tax lawyers to defend you in tax court.