What Is a Tax Audit and How Do You Prepare for One?

A tax audit is a formal examination of an individual’s or organization’s financial records and tax returns by a tax authority, such as the Internal Revenue Service (IRS) in the United States. Its purpose is to ensure the accuracy of reported income, deductions, and credits, verifying compliance with tax laws. An audit is a routine process and does not inherently indicate wrongdoing. Some audits conclude with no changes or even result in a refund for the taxpayer.

How Tax Audits are Initiated

The IRS selects tax returns for an audit using several methods. One method is computerized selection, where the IRS utilizes a Discriminant Function (DIF) system. This system assigns a numerical score to each tax return based on statistical formulas, comparing it against “norms” for similar returns to identify those with the highest probability of error or potential for unreported income. A higher DIF score suggests a greater likelihood of discrepancies, prompting further review.

Another common trigger is information matching, where the IRS compares information reported by taxpayers with data received from third parties. For instance, discrepancies between income reported on a tax return and amounts reported on W-2s from employers or 1099s from banks or other payers can flag a return. An audit of one taxpayer, such as a business partner or investor, might lead to a related examination of associated individuals or entities. A small percentage of returns are also selected randomly as part of research projects, like the National Research Program, to measure compliance levels. Unusually large deductions, high refunds, or business expenses that deviate significantly from industry averages can also draw attention to a return.

Types of Tax Audits

The IRS conducts audits through different methods, each varying in complexity and required interaction. The most frequent type is a correspondence audit, conducted entirely by mail. These audits address simpler issues resolved by submitting specific documentation, such as substantiating a charitable contribution or verifying a reported expense.

An office audit requires the taxpayer to attend a meeting at a local IRS office. These audits are generally more complex than correspondence audits, often focusing on specific income or expense items like itemized deductions or business profits and losses. An IRS audit officer conducts the interview and reviews the taxpayer’s records in person.

The most comprehensive type is a field audit, which takes place at the taxpayer’s home, business, or accountant’s office. Field audits are typically reserved for complex individual or business returns and involve a thorough examination of financial records. An IRS revenue agent conducts these in-depth reviews, which may include interviews with employees or observations of business operations.

Preparing for a Tax Audit

Upon receiving an audit notice, carefully read the document to understand its contents. The notice specifies the tax year(s) being audited and the particular items or documents the IRS is requesting.

Gather all relevant records that support the information reported on the tax return for the audited period. This includes:
Income documentation, such as W-2 forms, 1099 forms, and bank statements for self-employment income.
Expense and deduction records, including receipts, invoices, canceled checks, and credit card statements.
Supporting documents for deductions and credits, like medical bills, charitable contribution acknowledgments, mortgage interest statements, or educational expense records.

Organize these documents systematically for easy access and verification. Arranging records chronologically or by category can streamline the review process.

The Audit Process and Resolution

Once information is gathered, respond promptly to the audit notice, confirming receipt and scheduling any necessary appointments. During interactions with the auditor, whether by mail or in person, provide the prepared documentation clearly and directly. Answer questions truthfully, but avoid offering unnecessary information beyond what is requested.

Taxpayers have specific rights during an audit:
The right to professional representation by an attorney, Certified Public Accountant (CPA), or enrolled agent.
The right to understand why information is being requested and how it will be used.
The right to appeal if they disagree with the audit findings.

After reviewing documentation and discussions, the auditor will present their findings. Possible audit outcomes include:
No change: The audit concludes with no adjustments to the tax return.
Agreed: The IRS proposes changes, and the taxpayer agrees, signing an agreement form and arranging to pay any additional tax, penalties, or interest.
Unagreed: The taxpayer disagrees with the proposed changes. Taxpayers have the right to appeal the IRS’s decision through the IRS Appeals Office. An appeal requires a formal written protest outlining the reasons for disagreement, and it must be filed within 30 days of receiving the audit findings.