What Is an IRS Audit? The Process & What to Expect

An IRS audit is a formal review of an individual’s or organization’s financial records and tax returns by the Internal Revenue Service. Its purpose is to ensure reported information is accurate, complies with federal tax laws, and verifies the correct tax amount paid. Receiving an audit notice does not automatically imply wrongdoing. Audits are a routine part of tax administration and may even result in a refund for the taxpayer.

Understanding the Audit Process

Audit Selection Methods

The IRS employs several methods to select returns for examination, ensuring a targeted approach to compliance. These methods include statistical analysis, information matching, and related examinations.

Discriminant Inventory Function (DIF) Score

The Discriminant Inventory Function (DIF) score is a key element in the selection process. The IRS assigns a DIF score to each tax return, a numerical rating for potential errors or discrepancies. While the exact formula remains confidential, a higher DIF score suggests greater potential for issues, often based on deviations from norms for similar returns or income brackets. Returns with elevated DIF scores undergo further review by IRS agents before an audit is initiated.

Information Matching

Another significant selection method is information matching. The IRS receives copies of various information statements, such as W-2s from employers and 1099s from banks or other payers. These are compared against the income and other financial data reported on a taxpayer’s return. Discrepancies, such as unreported income, can trigger an audit. Additionally, the IRS may select a return for audit if it involves transactions or issues with other taxpayers, like business partners or investors, whose returns are already under examination.

Types of Audits

IRS audits generally fall into three main categories, each with varying levels of intensity and interaction.

Correspondence audits are the most common and least intrusive, typically handled entirely through mail. These audits usually address specific, simpler issues, such as missing documentation or discrepancies related to particular deductions.

Office audits involve a meeting at a local IRS office, generally for more complex issues that cannot be resolved through mail. These audits often focus on itemized deductions, business profits or losses, or rental income and expenses.

The most comprehensive type is a field audit, where an IRS agent conducts the examination at the taxpayer’s home, business, or accountant’s office. Field audits are typically reserved for complex business returns or when the IRS suspects significant discrepancies, often involving a thorough review of extensive financial records.

Preparing for an Audit

The initiation of an IRS audit begins with an official letter from the Internal Revenue Service. The IRS does not typically initiate audits via phone or email. Upon receiving such a notice, taxpayers should carefully read the letter to understand the specific tax year(s) being audited and the particular items or issues the IRS is questioning. The notice will also indicate the type of audit, whether it is a correspondence, office, or field audit, which helps in determining the next steps.

Understanding the Audit Scope

The audit notice or accompanying documentation will typically specify the information the IRS is requesting and the rationale behind the inquiry. For instance, it might ask for substantiation of certain deductions, income sources, or credits claimed on the return.

Gathering Required Documentation

Gathering all required documentation is a key preparatory step. The IRS requires taxpayers to maintain records that support the income, credits, or deductions reported on their tax returns, generally for at least three years from the filing date.

Commonly requested documents include income statements like W-2s and 1099s, receipts for expenses (business, medical, charitable contributions), bank statements, canceled checks, and investment records. Business owners may also need to provide ledgers, invoices, and records of vehicle expenses or home office deductions.

It is advisable to arrange documents chronologically by tax year and then by category of income or expense. Providing a summary of transactions can also be helpful for the auditor. While the IRS will typically accept electronic records, providing organized copies of all relevant documents is essential, and original documents should never be mailed.

Seeking Professional Advice

Seeking professional advice before interacting with the IRS can be a beneficial decision. Tax professionals such as Certified Public Accountants (CPAs), Enrolled Agents (EAs), or tax attorneys possess expertise in tax law and audit procedures. They can help interpret the audit notice, identify potential issues, and ensure all requested documentation is properly prepared and presented.

Navigating the Audit

After preparing the necessary documentation, the next stage involves direct interaction with the IRS. For correspondence audits, the initial contact and communication involve submitting the requested documents by mail within the timeframe specified in the audit notice, typically around 30 days. Taxpayers then await a response from the IRS.

Interacting with the Auditor

For office or field audits, the process usually begins with scheduling an appointment or confirming a visit. During the examination, whether in person or through correspondence, it is important to provide only the information specifically requested by the auditor. Taxpayers should be truthful and accurate in their responses, but avoid volunteering unnecessary details or speculating on answers. The auditor’s questions should be answered clearly and concisely, sticking strictly to the facts.

Taxpayer Rights

Taxpayers have several fundamental rights during an IRS audit, outlined in the Taxpayer Bill of Rights. These include the right to:
Professional and courteous treatment by IRS employees.
Privacy and confidentiality regarding tax matters.
Know why the IRS is asking for information and how it will be used.
Challenge the IRS’s position and appeal decisions.

Right to Representation

The right to representation is another important taxpayer right. Taxpayers can choose to represent themselves, or they can authorize a qualified tax professional, such as a CPA, Enrolled Agent, or tax attorney, to represent them. When a representative is authorized, they can communicate directly with the IRS on the taxpayer’s behalf, often attending meetings and providing requested information.

If a taxpayer is uncomfortable at any point during an in-person interview, they have the right to halt the discussion to consult with their authorized representative. The representative can guide the taxpayer on how to respond to questions and provide supporting documents.

Resolving the Audit

The audit process culminates in one of three possible outcomes, providing clarity on the tax return under review.

No Change Result

The first outcome is a “no change” result, meaning the IRS accepts the return as filed without any adjustments. This indicates that the taxpayer has successfully substantiated all reviewed items.

Agreed Case

The second outcome is an “agreed” case, where the IRS proposes changes to the tax return, and the taxpayer understands and consents to these adjustments. If the taxpayer agrees, they will typically sign a form, such as Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax, which formalizes their agreement to the proposed tax increase or decrease. This agreement generally leads to either an additional tax payment or a refund.

Unagreed Case

The third outcome is an “unagreed” case, which occurs when the taxpayer understands the IRS’s proposed changes but disputes them. In such instances, the IRS will generally issue a 30-day letter (such as Letter 525 or 950). This letter outlines the proposed adjustments and informs the taxpayer of their right to appeal the decision within 30 days.

Appeals Process

The appeals process offers an opportunity to resolve disagreements without resorting to litigation. The IRS Appeals Office is an independent administrative body within the IRS, separate from the examination division that conducted the audit. Its mission is to resolve tax controversies fairly and impartially, considering the facts and applicable tax law from both the taxpayer’s and the IRS’s perspectives. This office can also consider the “hazards of litigation,” meaning the likelihood of either side prevailing if the case were to go to court.

Judicial Review

If an agreement cannot be reached at the Appeals Office, the taxpayer still has recourse through the judicial system. They have the option to petition the U.S. Tax Court. This step allows for an independent judicial review of the dispute. If the Tax Court is petitioned, the case may still be settled out of court, but it provides a formal legal avenue for resolution.

Audit Conclusion

Upon the conclusion of an audit, whether agreed or determined through the appeals or court process, any additional tax due will be assessed, along with applicable interest and penalties. Conversely, if the audit results in an overpayment, the taxpayer will receive a refund. The IRS provides instructions on how to pay any outstanding balance or how refunds will be issued.