How Does a Tax Audit Work? The IRS Process Explained

A tax audit is a formal review conducted by the Internal Revenue Service (IRS) to verify the accuracy of information reported on a tax return. It ensures taxpayers comply with tax laws by correctly reporting income, deductions, and credits, and confirms the reported tax liability is accurate. This process involves examining an individual’s or organization’s financial records and related documents.

How Audits Are Selected

The IRS employs various methods to select tax returns for audit, aiming to identify those with the highest potential for errors or noncompliance. One primary mechanism involves computerized scoring, often referred to as the Discriminant Function System (DIF) score. This system uses algorithms to analyze tax returns for unusual patterns or discrepancies by comparing them against norms derived from similar returns. A higher DIF score indicates a greater likelihood of inaccuracies, prompting further review by IRS agents.

Another significant selection method is information matching. The IRS cross-references data reported on tax returns with information provided by third parties, such as employers (W-2s), banks (1099-INT), and brokers (1099-B). If the income or other details you reported do not match the information supplied by these third parties, the discrepancy can trigger an audit or a notice seeking clarification. The IRS also conducts random selections of a small percentage of returns for compliance research, which helps refine their audit selection models.

Certain characteristics or activities on a tax return might act as “red flags,” increasing the likelihood of an audit. These can include unusually high deductions relative to reported income, significant self-employment income, or consistent reporting of business losses over several years. Large cash transactions, claiming 100% business use of a vehicle, or excessive travel and entertainment deductions can also draw attention.

Understanding Your Audit Notice

Receiving an audit notice from the IRS is the first step in the audit process and requires prompt attention. These notices inform you that your tax return has been selected for examination and provide specific details. They state the tax year under review, the specific items or issues questioned, and the type of audit (mail, IRS office, or taxpayer location). The notice also includes a deadline for your response and IRS contact information.

Upon receiving an audit notice, it is crucial to read it carefully and completely to understand the IRS’s concerns. Ignoring the notice can lead to serious consequences, including the IRS making unfavorable adjustments to your tax return, assessing additional taxes, penalties, and interest, and potentially initiating collection actions like wage garnishments or bank levies.

You should immediately verify the tax year and the specific issues identified in the notice. Gathering all relevant financial documents, such as receipts, bank statements, and invoices, is an immediate next step. Seeking professional assistance from a tax professional or attorney early in the process can provide valuable guidance and representation.

The Audit Examination Process

Once an audit notice is received and understood, the examination phase begins, where the IRS reviews the taxpayer’s records and explanations. The method of examination depends on the type of audit.

The correspondence audit is the most common and is conducted entirely by mail. For this type of audit, the IRS sends a written request for specific documents or information, and the taxpayer mails back copies of the requested items, retaining original documents. Clear and concise responses are important, providing only the information specifically requested to avoid unnecessarily expanding the scope of the audit.

An office audit involves a meeting at a local IRS office, typically for more complex issues than those handled by mail. Taxpayers are expected to bring organized supporting documentation to this meeting. During the interview, the IRS agent will ask questions about the specific items under review, and taxpayers should provide factual answers supported by their records.

A field audit is the most comprehensive type, where an IRS agent visits the taxpayer’s home, business, or the office of their representative. These audits are more extensive, involving a thorough review of financial records, and may include observing business operations or interviewing employees if it’s a business audit.

Maintaining a professional and cooperative demeanor with the auditor is beneficial. Providing organized and complete documentation to substantiate all claims is crucial. Taxpayers should avoid volunteering unnecessary information beyond what is specifically requested. If a tax professional represents the taxpayer, they typically handle communication with the IRS, ensuring the audit remains focused.

Audit Outcomes and Your Rights

After the examination process concludes, the IRS will inform the taxpayer of the audit’s findings. There are several possible outcomes.

A “no change” outcome means the IRS agrees with the original tax return as filed, and no adjustments are made. If the IRS proposes changes and the taxpayer agrees with them, they sign an agreement form. This agreement allows for the immediate assessment and payment of any additional tax due.

If the taxpayer disagrees with the proposed changes, a formal disagreement process begins. The IRS will send a 30-day letter outlining the proposed adjustments and informing the taxpayer of their right to appeal the decision within the IRS Office of Appeals. This independent unit resolves tax disputes without litigation, offering an impartial forum. Taxpayers can submit a written protest within the specified timeframe, explaining their position and providing supporting documentation.

If an agreement is still not reached at the Appeals Office, or if the taxpayer chooses to bypass the appeals process, the IRS will issue a 90-day letter. This letter provides 90 days to petition the U.S. Tax Court if they wish to dispute the tax liability in court without first paying the disputed amount. The Tax Court is an independent judicial body where taxpayers can litigate their tax cases. Understanding and exercising taxpayer rights, including the right to professional representation, is important for navigating the process effectively.