What Is an IRS RAR and How Does It Affect Your Tax Obligations?

The IRS reviews tax returns to ensure accuracy, and when discrepancies arise, they issue a Revenue Agent Report (RAR). This document details adjustments made after an audit, which can impact tax liabilities. Understanding the RAR helps taxpayers assess the accuracy of the changes and their financial implications.

An RAR can result in additional taxes owed or, in some cases, refunds. Knowing how to interpret and respond to it is essential.

How the Report Is Generated

The RAR is created after an IRS audit, which may stem from income discrepancies, unusually high deductions, or random selection. An IRS agent examines financial records, tax filings, and supporting documents to verify reported figures. This review may include bank statements, business records, and payroll reports.

If inconsistencies arise, the agent may request more documentation or conduct interviews. Adjustments are then made based on IRS regulations and tax code provisions. These changes often involve unreported income, disallowed deductions, or misclassified expenses. The IRS follows specific guidelines, such as the Internal Revenue Manual and Treasury Regulations, to determine corrections.

Once the review is complete, the agent compiles findings into the RAR, detailing the proposed changes and their rationale. The report references applicable tax laws and IRS rulings and is sent to the taxpayer for review.

Key Items Detailed in the Document

The RAR outlines the IRS’s audit findings. A key section is the summary of adjustments, which lists modified line items, the dollar amounts, and their tax impact. For instance, if a business expense deduction is disallowed, the report specifies the amount removed and its effect based on the taxpayer’s tax bracket.

The report also cites tax laws and IRS regulations supporting the changes. If an education credit is denied due to ineligibility under Section 25A of the Internal Revenue Code, the RAR references this section and explains why. Similarly, if income is reclassified as self-employment earnings, it may cite Section 1402, which defines net earnings subject to self-employment tax.

Additionally, the report details penalties or interest resulting from the audit. If the IRS finds a substantial understatement of income, a 20% accuracy-related penalty under Section 6662 may apply. Interest accrues from the original return due date, calculated using the federal short-term rate plus 3%, updated quarterly. The RAR specifies the penalty amount and any accumulated interest.

Evaluating Adjustments and Figures

Reviewing the adjustments ensures the IRS’s calculations are correct. Changes should be analyzed in the context of tax laws and accounting principles. A common issue is the reclassification of expenses, which can significantly affect taxable income. If a capital expenditure is reclassified as a deductible business expense or vice versa, it impacts both current and future depreciation deductions under Section 168.

Taxpayers should also verify that adjustments properly account for carryforwards or carrybacks. Net operating losses (NOLs) can be carried forward indefinitely under current law, reducing future taxable income. If an RAR overlooks a valid NOL carryforward, the tax liability may be overstated. Similarly, tax credits like the General Business Credit under Section 38 allow for carrybacks and carryforwards, and adjustments to prior-year income can affect their availability.

The IRS may reconstruct income using bank deposit analysis or industry benchmarks. Taxpayers should ensure all deposits and transactions are correctly classified. Personal bank transfers, loan proceeds, or nontaxable income such as gifts may be mistakenly included as taxable revenue. Additionally, when the IRS adjusts income based on third-party reporting—such as discrepancies in Form 1099—taxpayers should verify that reported amounts match their records. Errors in reporting thresholds or misinterpretations of transactions can lead to unjustified tax increases.

Disputing or Agreeing With Proposed Changes

Deciding whether to accept or challenge the IRS’s findings requires analyzing the financial and legal implications of the proposed changes. Taxpayers should determine whether the IRS correctly applied substantiation requirements, especially for deductions and credits requiring specific documentation. For example, charitable contributions over $250 must be supported by a written acknowledgment under Treasury Regulation 1.170A-13(f). If a deduction is disallowed due to missing documentation, providing the correct records could resolve the issue.

The IRS’s interpretations and methodologies should also be scrutinized. The agency often uses industry standards or economic models to estimate income and expenses, but these assumptions may not reflect a taxpayer’s specific circumstances. In cases involving transfer pricing adjustments under Section 482, businesses must show that intercompany transactions follow the arm’s length standard. If the IRS applies a comparable uncontrolled price (CUP) method without considering functional differences, the adjustment may not be justified. A tax professional can conduct an independent analysis to assess the IRS’s position.

Steps for Finalizing the Outcome

Once a taxpayer has reviewed the RAR and determined their stance, the next step is to finalize the resolution. The IRS provides multiple options depending on whether the taxpayer agrees or disputes the findings.

Agreeing to the Adjustments

If the taxpayer accepts the IRS’s changes, they can sign Form 4549, “Income Tax Examination Changes,” agreeing to the adjustments. This waives the right to challenge the findings in Tax Court and commits the taxpayer to pay any additional liability. If immediate payment is not possible, the IRS offers installment agreements under Section 6159 for structured payments. For substantial liabilities, an Offer in Compromise under Section 7122 may allow for a reduced settlement based on financial hardship. Interest and penalties continue to accrue until the balance is fully paid.

Disputing the Adjustments

Taxpayers who disagree with the findings can request an administrative appeal through the IRS Independent Office of Appeals. This requires submitting a protest letter outlining disputed issues, relevant tax law interpretations, and supporting documentation. The Appeals Office operates separately from the audit division and focuses on resolving disputes without litigation. If an agreement is not reached, the taxpayer may escalate the matter to the U.S. Tax Court by filing a petition within 90 days of receiving a Notice of Deficiency. Litigation can be costly and time-consuming but may be necessary if the IRS’s position is legally or factually flawed. In some cases, taxpayers may seek relief through the U.S. District Court or the Court of Federal Claims, particularly if they have already paid the disputed amount and seek a refund.

Possible Impacts on Tax Obligations

The adjustments in an RAR can have long-term financial effects beyond the immediate tax year under review. Changes to reported income, deductions, or credits may impact tax liabilities, refund eligibility, and financial planning strategies.

One consequence is the potential for increased future tax burdens due to the loss of deductions or credits. If depreciation deductions under Section 167 are disallowed, future depreciation schedules must be recalculated, potentially increasing taxable income in later years. Adjustments to passive activity losses under Section 469 can also affect when losses can be deducted. Taxpayers should consider the impact on state tax filings, as many states conform to federal tax adjustments, leading to additional liabilities at the state level.

Another risk is increased IRS scrutiny in future tax years. If an audit results in significant adjustments, the IRS may flag the taxpayer for further examinations. This can lead to a higher likelihood of audits, increased documentation requirements, and potential penalties for repeated noncompliance. If the IRS determines negligence or substantial understatement of income, penalties under Section 6662 may apply. Strengthening record-keeping practices can help mitigate these risks.