What Does a Tax Audit Mean and What Should You Expect?
Understand what a tax audit entails and how to navigate the process with confidence.
A tax audit represents a formal review by a tax authority of an individual’s or organization’s financial information and tax returns. It verifies the accuracy of reported income, deductions, credits, and other financial details. The objective is to ensure compliance with tax laws.
Understanding Why Audits Occur
Audit selection can occur for several reasons. Some tax returns are chosen randomly as part of routine compliance initiatives. Random selection helps identify common errors or areas needing stronger compliance efforts.
Another common trigger is a discrepancy between the income reported on a tax return and information received from third parties. For example, if a Form W-2 from an employer or a Form 1099 from a financial institution or client reports income that does not match the amount listed on the tax return, it can lead to an inquiry. Similarly, unusually high deductions relative to an individual’s income level, such as significant business losses reported on a Schedule C or large itemized deductions, may attract attention.
Significant changes from previous tax returns, such as a sudden large decrease in reported income or the introduction of substantial new deductions, are also a factor. Tax authorities use data analysis to identify patterns that deviate significantly from typical filing behaviors. Even simple mathematical errors or missing information on a tax return can trigger an audit notice, prompting a review to correct inconsistencies.
Gathering Information and Preparing for an Audit
Upon receiving an audit notification, read the entire letter. This document will specify the type of audit, the tax years under review, the specific items being questioned, and the deadline for response or meeting.
Gathering all relevant documentation supporting the entries on the tax return. This includes income statements like W-2s and various 1099 forms, receipts for all claimed deductions and expenses, bank statements, and canceled checks. For instance, if business expenses are claimed, detailed ledgers, invoices, and payment records are necessary.
It is advisable to review the original tax return in question for any potential errors or omissions before engaging with the tax authority. This internal review can help identify areas that may require additional documentation or explanation. Many individuals choose to consult with a tax professional, such as a Certified Public Accountant (CPA) or a tax attorney, who can provide guidance, help organize documents, and represent them during the audit.
Navigating the Audit Interaction
Once preparation is complete, the audit interaction typically begins, often through mail, phone, or an in-person meeting. Correspondence audits are common for simpler issues and involve exchanging documents and information via postal mail or secure online portals. For more complex matters, an office audit may require the taxpayer to meet with an auditor at a tax authority office, or a field audit may occur at the taxpayer’s home or business location.
During any interaction, provide only the information and documents specifically requested by the auditor. Volunteering additional, unsolicited details can sometimes lead to new inquiries or expand the scope of the audit. All submitted documents should be clear, legible, and organized according to the auditor’s instructions.
Responding to inquiries should be done clearly and concisely, adhering to all specified deadlines. If a question is unclear, it is appropriate to ask for clarification rather than making assumptions. Maintaining a professional and cooperative demeanor throughout the process helps facilitate a smoother experience, even when disagreements arise regarding tax law interpretations or documentation sufficiency.
Possible Audit Results
After reviewing all submitted information, several audit outcomes are possible. In some cases, the audit may conclude with “no change,” meaning the tax return is accepted as filed. This confirms the accuracy of the original return.
Another possibility is that the audit reveals an overpayment of tax, leading to a refund for the taxpayer. This can occur if the audit uncovers deductions or credits that were overlooked during the initial preparation of the return. Conversely, the audit may determine that additional tax is owed due to errors, disallowed deductions, or unreported income.
If additional tax is assessed, penalties and interest may also apply. Accuracy-related penalties, such as those for negligence or substantial understatement of tax, often amount to 20% of the underpayment. Interest typically accrues on any underpayment from the original due date of the tax return until the new amount is paid in full.