What Are Tax Audits: Types, Triggers, and Process

A tax audit is an IRS review of an individual’s or organization’s financial records and tax returns. Its primary purpose is to verify that reported information is accurate and complies with tax laws, ensuring the correct amount of tax has been paid.

Understanding Tax Audits

The IRS conducts tax audits to confirm the accuracy of a taxpayer’s financial information and adherence to tax regulations. Audits minimize the “tax gap,” the difference between taxes owed and collected. There are three main types of IRS audits, varying in scope and interaction.

Correspondence audits are the most common and simplest, conducted entirely by mail. They focus on specific issues like missing documentation or discrepancies related to income, expenses, or tax credits. Taxpayers receive a letter requesting additional information.

Office audits involve an in-person meeting at a local IRS office. They address more complex issues than correspondence audits, often concerning itemized deductions, business income and expenses, or rental income. Taxpayers must bring specific documents for review by an IRS examiner.

Field audits are the most comprehensive type of examination. Conducted by an IRS agent at the taxpayer’s home, business, or representative’s office, they are typically reserved for complex returns or business activities. They involve a thorough review of extensive financial records, interviews, and sometimes observation of business operations.

How Tax Audits are Initiated

The IRS employs various methods to select tax returns for audit; selection does not necessarily mean an error or dishonesty occurred. Some returns are chosen as part of research and compliance efforts to update statistical data.

Computerized selection systems play a significant role. These systems assign a score to each tax return by comparing it against statistical norms for similar returns. Returns with scores that deviate significantly, indicating a higher potential for change in tax liability or unreported income, are flagged for review.

Information matching is another common method, where the IRS compares information reported by third parties with what the taxpayer reported. For example, if income on a W-2 or 1099 form does not match the tax return, this discrepancy can trigger a notice or an audit.

Returns can also be selected through related examinations. If a business partner or another entity with whom a taxpayer has transactions is audited, the taxpayer’s return might also be selected. This helps the IRS ensure consistency across interconnected financial activities.

A small percentage of returns are selected purely at random as part of the National Research Program. This helps the IRS gather data to improve audit selection algorithms and ensure compliance. These random audits can occur even if no apparent discrepancies exist.

Certain situations or “red flags” can increase the likelihood of an audit. These include unusually high deductions relative to income, significant income fluctuations, substantial self-employment income, or large cash transactions. Claiming certain credits like the Earned Income Tax Credit (EITC) may also lead to increased scrutiny.

Responding to a Tax Audit

Upon receiving an audit notification, understanding its contents is paramount. The notice will specify the tax year(s) under examination, the type of audit, and the items or issues the IRS wants to review. Identify the requested documents and the deadline for response.

Gather all relevant documentation, including receipts, invoices, bank statements, and any other records supporting questioned income, deductions, or credits. Organize these records systematically to facilitate the examination process. Maintaining thorough records for at least three years after filing is recommended, as the IRS can audit returns within this period, or up to six years if a substantial error is identified.

Considering professional assistance is often advisable, particularly for office or field audits or complex issues. Tax professionals such as Certified Public Accountants (CPAs), Enrolled Agents (EAs), or tax attorneys can represent taxpayers before the IRS. They help interpret the audit notice, organize documentation, communicate with the IRS, and advocate on the taxpayer’s behalf. Taxpayers have the right to representation and can halt an interview to consult with a representative.

When communicating with the IRS, responding promptly and adhering to deadlines is essential. For correspondence audits, requested documents should be mailed by the specified due date. For in-person audits, an appointment will need to be scheduled. If more time is needed to gather documents or prepare, taxpayers can generally request an extension.

During the examination process, the examiner will review documents, ask questions, and may request additional information. Taxpayers have fundamental rights during an audit, including the right to professional treatment, privacy, and confidentiality regarding their tax matters. They also have the right to know why the IRS is asking for specific information and how it will be used. Taxpayers can challenge the IRS’s position and provide additional documentation to support their case.

Concluding a Tax Audit

An IRS audit can conclude with several outcomes. One is a “no change” letter, meaning the IRS found no errors or insufficient changes to warrant tax return adjustments. This indicates the taxpayer substantiated all reviewed items.

Another outcome is an “agreed” case, where the IRS proposes changes, and the taxpayer agrees with these adjustments. This may result in additional tax owed, a refund, or no change in tax liability. If an agreement is reached, the taxpayer typically signs a form acknowledging the changes, and the audit is closed.

If the taxpayer disagrees with proposed changes, the case becomes “disagreed.” Taxpayers have the right to challenge IRS findings and can pursue an appeal within the IRS for further review of disputed issues.

The appeals process provides an independent administrative review of audit findings. The IRS Office of Appeals is separate from the initial audit function, aiming to resolve disputes impartially without litigation. To initiate an appeal, a taxpayer generally submits a formal written protest within 30 days of receiving the IRS audit findings letter. This protest should outline the items of disagreement, supporting facts, and relevant legal authority.

For disputed amounts of $25,000 or less, a simpler “small case request” may be available. Once an appeal is filed, an appeals officer reviews the facts and law, considering both the taxpayer’s and the IRS’s positions to reach a mutually agreeable resolution. The appeals process is designed to avoid court intervention, and appeals officers can settle cases based on the “hazards of litigation,” which means evaluating the probable outcome if the case were to go to court.

If an agreement cannot be reached at the appeals level, taxpayers have further options. These include petitioning the U.S. Tax Court, filing a suit in a U.S. District Court, or the U.S. Court of Federal Claims. The Tax Court generally allows taxpayers to dispute a deficiency without paying the tax first, while other courts typically require the tax to be paid before a refund suit can be filed.