What Does Being Audited Mean in Taxes?

A tax audit is a formal examination conducted by the Internal Revenue Service (IRS) or a state tax authority. It reviews an individual’s or organization’s financial records to verify the accuracy of a tax return. The process ensures reported information aligns with tax laws and verifies the correct tax paid. The goal is to assess tax liability, determine any refunds owed, or highlight outstanding taxes due. Audits maintain the integrity of the tax system and ensure compliance.

Understanding a Tax Audit

There are generally three types of IRS audits.

Correspondence Audits

A correspondence audit is the most common and least intrusive, handled entirely by mail. These audits focus on specific, simpler issues like missing documentation, errors in calculations, or unreported income, often requesting additional information or clarification through a letter.

Office Audits

An office audit involves a taxpayer visiting an IRS office for an in-person interview. These audits are more detailed than correspondence audits and usually address more complex issues such as itemized deductions, business profits or losses, or rental income and expenses.

Field Audits

A field audit is the most comprehensive type, where an IRS agent conducts an in-depth examination at the taxpayer’s home, place of business, or accountant’s office. Field audits are reserved for complex cases, often involving businesses or high-income individuals, and may cover many items on a return.

Reasons for an Audit

Tax returns can be selected for an audit through various methods, and selection does not always imply wrongdoing. One method is random selection and computer screening, where returns are compared against “norms” for similar returns using statistical formulas. These statistical formulas, such as the Discriminant Information Function (DIF) system, assign a score to each return, and a high score might trigger an audit.

Certain discrepancies or “red flags” can also increase the likelihood of an audit.

Failing to report all taxable income, especially when third parties like banks or employers report it to the IRS (e.g., via Forms W-2 or 1099), is a common trigger.
Large or unusual deductions relative to income or industry norms, such as excessive business expenses, home office deductions that don’t match reality, or disproportionately large charitable contributions, can also draw attention.
Mathematical errors, rounding or estimating dollar amounts, or claiming credits for which one is ineligible can lead to an audit.
Significant changes in income from one year to the next, consistent business losses, or issues related to foreign accounts and cryptocurrency transactions can prompt an examination.

Responding to an Audit Notice

Upon receiving an official audit notice, typically sent by mail, the first step is to carefully review it. The notice will specify the tax year(s) being audited, the type of audit, and the specific issues or documents the tax authority wants to examine. Verify the authenticity of the notice, as the IRS will never initiate an audit by phone, email, or social media.

Next, begin gathering and organizing all requested documentation that supports the items being questioned. This may include:

Receipts
Invoices
Bank statements
Canceled checks
Loan agreements
Legal documents
Any other records used to prepare the tax return

Organize these documents systematically by year and type of income or expense, and consider creating a summary sheet to accompany them. Send only copies of documents, never originals. If more time is needed to gather records, contact the tax authority to request an extension, responding promptly by the specified deadline. Seeking professional help from a tax professional, enrolled agent, or Certified Public Accountant before responding is advisable, as they can represent you and help navigate the process.

The Audit Process

During the audit, the interaction with the auditor depends on the type of audit. For correspondence audits, taxpayers mail the requested documents to the tax authority. For office or field audits, taxpayers, often accompanied by their representative, attend a meeting where documents are presented and reviewed.

The auditor examines the provided documents and may ask questions to clarify information on the tax return. Be honest, concise, and cooperative in responses, providing only the information specifically requested. The auditor’s role is to assess compliance with tax laws, not to intimidate. Based on the examination, the auditor may propose adjustments to the tax liability if discrepancies are found.

Audit Outcomes and Next Steps

An audit can conclude in one of three ways.

No Change Outcome

A “no change” outcome means the tax authority accepts the return as filed, finding no issues.

Agreed Outcome

An “agreed” outcome signifies the taxpayer understands and agrees with the proposed changes, which may result in additional tax due, penalties, or interest. If the taxpayer agrees, they sign an agreement form, such as Form 870, which waives restrictions on assessment and collection of the deficiency.

Disagreed Outcome and Appeals

If the taxpayer “disagrees” with the auditor’s findings, they have the right to appeal the decision. The appeal process begins with filing a formal written protest within 30 days of receiving the audit findings, outlining the reasons for disagreement and providing supporting evidence. The case may then be reviewed by an independent Appeals Office, which aims to resolve disputes without litigation. If an agreement is not reached, further legal avenues, such as Tax Court, may be pursued.