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 You've prepared your income tax return, filed it with the IRS, and now comes time for the waiting game. Although this time around you're not just waiting for a tax refund - you're waiting to see if you're going to be involved in a tax audit.
Tax Audits
In this article we're hoping we can relieve some of the anxiety around the prospects of getting audited by the IRS. We'll start by providing some hard facts on the odds of actually being audited. Then we're going to talk about the three types of audits the IRS conducts. Finally we'll give you some hints on how to avoid an audit in the first place, as well as some tips on dealing with auditors.
Odds of Being Audited
Let's start off by saying the overall risk of being audited is very low, and the risk of being involved in a sit-down audit is even lower. And even when the IRS targets a taxpayer for an audit they are usually only interested in learning more about one or two elements of the filing - not the entire tax return.
- In 2006 the IRS conducted approximately 1,300,000 audits. To put that number in perspective you need to consider there were roughly 132 million tax returns filed in that year. That means your odds of being audited were less than 1% or 1 in 100.
- If you made less than $100,000, then your odds of being audited were even less than 1%. In fact the audit rate for this group of taxpayers was only 0.89% or roughly 1 in 110.
- If you made more than $100,000 but less than $1,000,000 then your odds of being audited nearly doubled to 1.67% or 1 in 60.
- And if you happened to make more than $1,000,000 your risk of being audited increases to around 6% or approximately 1 in 17 tax returns.
The risk of being audited increases with income level for two reasons. The first reason has to do with the complexity of the tax return. Upper income individuals and families usually file more complex tax returns so it's easier to make a mistake. In addition, the IRS uses complex computer models to try and maximize their chances of recovering money during an audit. So tax returns involving higher sums of money automatically increase the odds of the IRS recovering more money.
Three Types of Tax Audits
Even if you're audited by the IRS, that doesn't mean you're going to have an auditor visit your home. In fact there are three types of audits that the IRS conducts, each with increasing levels of complexity:
- Automated Inquiries
- Correspondence Audits
- Field Audits
Automated Inquiries
An automated inquiry is arguably not even an audit. It's basically a discrepancy the IRS found between your tax return and the information they've received from another party such as your employer or bank. This type of audit usually happens within months of filing your return. And most of the time a discrepancy inquiry will be settled by appeal or payment of additional taxes owed.
Correspondence Audits
Approximately 77% of all audits conducted by the IRS are correspondence audits. Even for taxpayers making over a million dollars a year, nearly 60% of those audits were correspondence audits meaning that only 3.4% of these taxpayers were subjected to field audits. A correspondence audit involves a letter from the IRS usually disputing two or more elements of a tax return that do not appear to be correct.
Correspondence audits usually require the taxpayer to submit additional documentation to clarify what appears on the tax return. Once those documents have been reviewed by the IRS, the agency will issue a proposed amendment to your tax return. As is the case with an inquiry, the judgment resulting from a correspondence audits can be appealed.
Field or Desk Audits
The most thorough type of audit the IRS conducts is a field or desk audit. This type of audit involves actually meeting with an IRS agent and reviewing one or more tax returns. Unlike an inquiry, a sit-down audit may take place several years after filing a return
Ways to Avoid a Tax Audit
With a 132 million tax returns to sift through the IRS relies on automation to help them raise a "red flag" when something on a tax return looks suspicious. And almost all the precautions you can take to avoid a tax audit revolve around the proper reporting of income and deductions on your tax return.
Properly Reporting Sources of Income
There are two important things to keep in mind when it comes to reporting income on your tax return:
- Reporting income on the proper tax form - this includes reporting W-2 information on line 7 of form 1040 as well as using reporting non-employee compensation (1099-MISC) on Schedule C.
- Ensuring the income reported is correct - this includes information on your W-2 as well as making sure the proper Social Security number is associated with the income that individual generated. This also includes making sure tips and cash payments that serve as income are not under-reported
If you're not sure where to report certain sources of income, there are lots of options you have with respect to tax preparation help. This includes the tax forms themselves, automated telephone instructions, as well as help available from local offices of the IRS.
Documenting Tax Deductions
When it comes to tax deductions, the key to staying out of trouble with the IRS is to keep detailed records. If you're taking a tax deduction that might be viewed as unusually high relative to prior past tax returns it might be appropriate to attach information that substantiates such claims. If complex calculations are involved, then attach that documentation too.
Above all, follow the directions found on the IRS tax forms you're using. For example, one of the more common mistakes is taking the same tax deduction twice - including taking the deduction in multiple places such as Schedules A, C, and E. Another common error is rounding to the nearest ten dollars or hundreds of dollars instead of rounding to the nearest dollar.
Dealing with an Auditor
If you used a professional service to help prepare your income taxes, then that service provider will usually help you during an audit. That same provider may charge a fee to help represent you during an audit unless the audit itself was a direct result of a mistake made by the tax service itself.
Many of today's tax preparation software providers offer some form of an audit insurance policy. For example, H&R Block provides a free service with its TaxCut software package called WorryFree Audit Support while Intuit's TurboTax provides a service called Audit Defense for a fee.
If you prepared your taxes yourself, then you always have the option of representing yourself during an audit. Alternatively you can always hire a CPA, an attorney, or a licensed tax preparer to help. The decision to hire a professional usually depends on the number and complexity of the audit findings themselves as well as your person comfort in dealing with the stress of meeting with an auditor.
About the Author - Avoiding a Tax Audit
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