The IRS Audit Rules and Examination Process

An Internal Revenue Service (IRS) audit is a review of an individual’s or organization’s financial information to confirm that the tax return is accurate and complies with tax laws. Receiving an audit notice does not inherently mean a mistake has been made. Some examinations result in no change to the tax return, or even a refund.

How the IRS Selects Returns for Audit

The IRS uses several methods to select tax returns for examination, with a primary one being a computerized system. This system, known as the Discriminant Information Function (DIF), assigns a numeric score to each return based on its potential for error. The DIF formula is based on historical data from past audits and identifies returns with characteristics that deviate significantly from the norm for similar returns. A high score flags a return for review by an IRS employee who decides if an audit is warranted.

Another selection method is information matching. IRS computers compare information on a tax return with third-party documents, such as Form W-2 from employers and Form 1099 from clients. If there is a mismatch, such as unreported income, the system generates a notice, like the CP2000, asking for an explanation. An unresolved mismatch can lead to a full audit.

Returns can also be selected through random screening or as part of the National Research Program, which helps the IRS update its DIF scoring formulas. An audit can also be triggered by association with another taxpayer under examination, such as a business partner or investor. Information from other sources, including public records or informants reporting suspected tax evasion, can also lead to an audit.

Understanding the Types of Audits

The IRS conducts audits in several formats. The most common is the correspondence audit, handled entirely by mail. These audits focus on a few specific items, such as verifying deductions, income, or tax credits, and represent the majority of IRS examinations. The taxpayer receives a letter, often a Form 566, requesting documents to support the items in question.

A more involved format is the office audit, which requires the taxpayer to visit an IRS office for an in-person interview. This audit is broader than a correspondence audit and may cover several issues, such as those related to itemized deductions on Schedule A, business profits and losses on Schedule C, or rental income on Schedule E. The notification letter specifies the issues and the records the taxpayer needs to bring.

The most comprehensive type is the field audit, where an IRS agent conducts the examination at the taxpayer’s home, business, or accountant’s office. Field audits can cover the entire tax return and often extend to multiple tax years. They are more common for businesses or individuals with complex finances.

Navigating the Examination Process

Once an audit begins, the IRS examiner will formally request information using an Information Document Request (IDR), or Form 4564. This form lists the specific records needed, such as receipts, bank statements, or loan agreements. The taxpayer is responsible for providing documentation that substantiates the items on their tax return.

Throughout the examination, taxpayers are protected by the Taxpayer Bill of Rights. This includes the right to professional treatment and the right to representation. A taxpayer can handle the audit themselves or authorize a qualified professional, like a CPA or attorney, using Form 2848, Power of Attorney and Declaration of Representative.

The examination process follows a structured timeline. If a taxpayer needs more time to gather documents, they can request an extension; for audits by mail, the IRS can grant a one-time automatic 30-day extension. The IRS has three years from the date a return was filed to initiate an audit, which can be extended to six years if a substantial error is found. If a request for information is unclear, the taxpayer or their representative can discuss it with the examiner to clarify the scope without providing unrequested records.

Concluding the Audit and Next Steps

An IRS audit concludes in one of three ways: no change, agreed, or unagreed. A “no-change” outcome means the return was accurate as filed. If the examiner proposes changes and the taxpayer agrees, the case is “agreed.” The taxpayer will be asked to sign an agreement form, such as Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment, and will receive a report detailing the adjustments.

If the taxpayer disagrees with the proposed changes, the case is “unagreed.” The examiner then prepares a Revenue Agent Report (RAR) explaining the findings and issues a “30-day letter.” This letter notifies the taxpayer of the proposed deficiency and outlines their options within a 30-day window.

The taxpayer can agree with the findings and pay the tax. Another option is to challenge the findings by requesting a conference with the IRS Independent Office of Appeals. If the taxpayer does nothing, the IRS will issue a Statutory Notice of Deficiency, also known as a “90-day letter,” which is required before one can petition the U.S. Tax Court.

The Formal Appeals Process

To dispute the findings in a 30-day letter, a taxpayer can enter the formal appeals process by filing a written “protest” with the IRS. This protest letter outlines the taxpayer’s specific disagreements with the examiner’s findings, presenting the facts, law, and arguments that support their position. This moves the case to the IRS Independent Office of Appeals, a separate body within the IRS tasked with resolving tax controversies without litigation.

Appeals officers provide an impartial review and have the authority to consider the “hazards of litigation.” This means they can evaluate the strengths and weaknesses of both sides to predict a likely court outcome. This flexibility allows them to propose settlements that may involve concessions.

The appeals conference is an informal meeting where the taxpayer or their representative presents their case to the appeals officer to reach a resolution. If an agreement is reached, it is documented on a form like Form 870-AD. This form contains pledges from both parties not to reopen the case for the agreed-upon issues. If no settlement is reached, the appeals process concludes.