Taxation and Regulatory Compliance

What Is the Purpose of an IRS Audit?

Demystify IRS audits. Learn their fundamental purpose, how the IRS conducts them, and what to expect from notification to resolution.

The Internal Revenue Service (IRS) is the federal agency tasked with collecting taxes and enforcing tax laws. It funds government operations by processing tax returns and collecting revenues. IRS audits verify the accuracy of information reported on tax returns.

Understanding Audit Objectives

IRS audits primarily aim to ensure the integrity and fairness of the federal tax system. A main goal is to verify the accuracy of reported income, deductions, credits, and other financial details on tax returns. This process confirms compliance with federal tax laws.

Audits also promote fairness, ensuring everyone contributes their correct share of tax revenue. Audit oversight deters non-compliance, encouraging accurate reporting. Ultimately, audits aim to collect the correct tax revenue.

How Returns Are Selected

The IRS uses various methods to identify tax returns for audit. One tool is the Discriminant Function (DIF) system, a computerized scoring system. This system assigns a score to each return, indicating potential for error or non-compliance; higher scores often lead to further review.

Another method is information matching, where the IRS compares data on tax returns against information from third parties, such as W-2 or 1099 forms. Discrepancies can trigger an audit. If a business partner or investor is audited, their associated tax returns may also be selected. Some returns are chosen randomly as part of the National Research Program (NRP), which gathers data to measure tax compliance and inform future IRS strategies. Other triggers include tips from informants or unusual financial transactions.

Common Audit Types

IRS audits are conducted in three primary ways, each varying in scope and method. The most frequent type is a correspondence audit, handled entirely by mail. These audits address simpler issues, such as verifying specific deductions or income, and can often be resolved by submitting documentation through the mail.

For matters requiring more detailed scrutiny, the IRS conducts office audits. These involve the taxpayer meeting with an IRS examiner at a local office. Office audits are more comprehensive than correspondence audits but less extensive than field audits, often focusing on specific sections of a return like itemized deductions or business profits.

The most thorough type is a field audit, where an IRS revenue agent conducts the examination at the taxpayer’s home, business, or representative’s office. Field audits are reserved for complex individual or business returns requiring extensive review of financial records and direct interaction.

Responding to an Audit Notice

Upon receiving an audit notice, understanding its contents is the first important step. Taxpayers should read the notice, such as a CP2000, Letter 2000, or Letter 2205, to identify the specific tax year and issues questioned by the IRS. This review clarifies the nature and scope of the audit.

After understanding the notice, gathering all relevant supporting documentation for the questioned items is important. This may include receipts, invoices, bank statements, canceled checks, mileage logs, and investment statements. Organizing these records systematically facilitates the review process and ensures necessary information is readily available.

It is important to adhere to the response deadline specified in the audit notice. Missing this deadline can lead to complications, including automatic adjustments to tax liability. Taxpayers can seek assistance from a qualified tax professional, such as a Certified Public Accountant (CPA), Enrolled Agent (EA), or tax attorney, for representation and guidance.

Audit Outcomes

Once an IRS audit concludes, there are several possible outcomes. One favorable result is a “no change” outcome, meaning the IRS agrees with the original tax return as filed, and no adjustments are made. This indicates accurate reporting of income and deductions.

Another outcome is an “agreed” case, where the taxpayer consents to the proposed changes. In this scenario, the taxpayer signs an agreement form, such as Form 4549 or Form 870, acknowledging the adjustments. This agreement may result in additional tax owed, a refund, or a revised tax liability.

Alternatively, if the taxpayer disagrees with the proposed changes, the case becomes “unagreed.” In such instances, the taxpayer can appeal the IRS’s findings to the IRS Appeals Office. If an agreement is not reached at the Appeals level, the IRS will issue a Notice of Deficiency, often called a 90-day letter, allowing the taxpayer to petition the U.S. Tax Court.

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