Tax audit is a process. There are systematic steps and discipline involved. Tax audits can potentially affect anyone, including self-employed individuals and corporate entities. Though many business owners worry about potential audits, the audit procedure is most often not as stressful as popular culture makes it out to be. Not all returns selected for audit contain severe errors, and some audits result in additional refunds for the individual or company that the IRS audits.
Tax audits can be conducted by the IRS and by State departments of taxation.
- The following information is based upon IRS tax audits, just keep in mind that most state audit processes and procedures are fairly similar to the IRS.
- The purpose of a tax audit is to verify that the tax reported is correct.
- Most of the time when the IRS selects your return for an audit it is because statistically there is a problem based upon the numbers you provided.
- Being selected doesn’t always mean there is a problem, sometimes you may actually be due a refund after the audit or the IRS accepts your tax return as is.
- Each year small businesses rush to complete their tax returns before the Internal Revenue Service’s (IRS) April 15 deadline.
- Accountants and financial advisors are engaged to ensure that the companies are not among those selected to be audited.
- Although an IRS audit can inspire fear in many entrepreneurs, it is a less common practice than many realize.
- The IRS informs individuals and businesses who are being audited by mail.
- The notification letter tells the recipient details about their audit and lists materials that the IRS needs to complete the audit procedure.
- The recipient should respond to the letter to acknowledge receipt and confirm the audit scheduling.
- The IRS performs some audits by sending audit forms through the mail.
- The form includes information for the individual or company to confirm and may request additional information on some claims listed in the return.
- The IRS conducts interview audits at either a local IRS office or at the home or business of the individual being audited.
- During the interview, the IRS agent asks for clarification on claims contained within the tax return and suggest changes to the return.
- The audit concludes when the individual being audited and the IRS agent reach an agreement concerning the return and any changes that it may need.
- The IRS will notify a small business by mail of a pending audit.
- In the event that an entrepreneur receives an email regarding an upcoming audit, she should contact the IRS immediately.
- This communication never occurs through email, and any email purporting to be from the IRS is a scam.
- The correspondence informs her of a date by which she must contact the agency to schedule the audit.
- In addition, the document informs the entrepreneur of paperwork that must be produced during the audit.
How tax returns are selected for an audit?
The IRS selects tax returns for audit review using several different methods. Returns that indicate the filer may be involved with tax avoidance transactions or tax shelters have an increased likelihood of selection, as do returns that are flagged by computer analysis as potentially having errors. Returns with information that does not match that on other tax documents have an increased audit likelihood, as well. Large corporations are often subject to yearly audit because of the large amounts of money that they receive and pay out.
- The IRS uses many different factors when selecting which returns it is going to audit.
- The majority of tax audits are determined by computers.
- The IRS has several different computer systems that do various types of analysis on returns that do statistical analysis to score tax returns based on their likelihood of being correct.
The IRS also chooses audits based off of other non computer related analysis as well, all methods are described below:
- The Discriminant Function System (DIF)
- The Unreported Income Discriminant Function (UIDIF)
- The Information Returns Processing System (IRP)
- Incriminating Documents Turned Over to IRS
- Audits of Related Entities
Document all income:
- One of the first steps an IRS auditor takes when performing a tax audit on a small business is a review of the organization’s financial records.
- This is done to ensure that all income has been properly reported.
- By ensuring that all documents related to the receipt of income are available, an entrepreneur can ensure that the audit is expedited.
- Receipts from every sale should be retained for this purpose, as should the business’ general financial ledger.
- The auditor will go through this document with a fine-tooth comb.
- A small business owner also should keep detailed records of any financial gifts such as inheritances that have gone into the business.
- This is taxable income that must be accounted for.
- In addition, any bartering that has occurred, such as providing services in exchange for valuable goods, such as office equipment, must be noted.
|Remember: Not documented = Not audited|
Types of Audits once selected:
Once the IRS determines that it would like to follow through and get more information about your tax return, they will send a letter stating that your return has been selected for an audit. Below are the 3 different examination methods used by the IRS.
- Correspondence Audit: This is the most common type of audit and is done by mail. The IRS will normally request specific documentation to support particular items on the tax return.
- Field Audit: This is when the IRS wants to come to your home, place of business, or your tax professionals office to perform the audit. This is the least common form of audit and is only used if the individual or business being audited earned well over $100K.
- Office Audit: This is when you are required to go to an IRS office to meet with an IRS auditor. The IRS will determine the time and the particular documents that it would like you to bring for support.
What happens after an audit?
After the audit you will either be handed or mailed IRS Form 4549, which is the IRS examination report and will show the proposed changes to tax liability. This form will provide a clear explanation of any adjustments made. The report will either state that you have had no changes or you are due a refund (no action required on your part, you won!) or it will state the changes that have been made and you owe more taxes plus interest and penalties. You have two options once you receive this, you can approve their findings or you can choose to disagree with their findings, each described in more detail below.
- Approve of Audit Findings: If you agree with the proposed changes then you should sign and return a copy of the report with IRS Form 870. IRS Form 870 is the Consent to Proposed Tax Adjustment. Once you sign the form you are agreeing that you have a tax deficiency and the additional tax penalties and interest that are listed on your examination report as well. If you owe more taxes than you can afford to pay in full then you can request to pay through a payment plan. The payment plan you use will be determined by how much money you owe and how much you can afford to pay monthly.
- Disapprove of Audit Findings: If you don’t approve of the findings in the examination report then you will have 30 days to do any of the following:
- Mail in additional documents you would like them to consider,
- Request a discussion on the findings with the examiner (you can do this and submit additional information to be considered).
- Discuss your case with the group manager or senior manager
- Request an appeal: If you do not agree with the proposed changes and you were not able to clear up the disagreement with the examiner than an appeal could be a good possibility.
You will have 30 days to consider the proposed adjustments after receiving the examination report. If you do not respond within 30 days then the IRS will send a notice that your case is considered not agreed and if you will have only 30 more days to file for an appeal or the IRS findings will become final.
- Individuals and businesses can appeal audits and any changes suggested during the audit procedure within 30 days.
- The individual or business makes an appeal with the supervisor of the auditor who performed the audit, with the IRS directly, in the U.S. Court of Federal Claims or in U.S. District Court.
- If a party does not appeal within 30 days, the IRS issues a statutory notice of deficiency. Appeals to this notice are made in tax court within 90 days of the date it is issued.
- If a party does not appeal an audit or a statutory notice of deficiency within the allowed time period the individual or business that was audited must pay any amount owed as a result of the audit.