Why Does Code 420 Examination of Tax Return Appear on My Transcript?

Receiving a tax transcript with Code 420 can be an unsettling experience for many taxpayers. This code indicates that the IRS has decided to audit your return, leading to further scrutiny of your financial activities. Understanding why this occurs and what it entails is crucial for navigating the process effectively.

Why Code 420 Appears on a Tax Transcript

Code 420 on a tax transcript signifies that the IRS has initiated an examination of your tax return. It is not assigned randomly but is typically triggered by factors that raise concerns during the IRS’s review. One common reason is discrepancies between the information reported on your return and data from third-party sources, like W-2s or 1099s. The IRS’s systems are designed to flag such inconsistencies, prompting a closer look at your records.

Another reason may be unusual or complex transactions that deviate from typical patterns. For example, a significant rise in income without an increase in reported expenses might prompt the IRS to verify the accuracy of these figures. Similarly, disproportionate deductions or credits, such as those for business expenses or charitable contributions, can attract attention if they appear inconsistent with your income.

In some cases, the IRS may select a return for examination as part of a random compliance check. This helps the agency evaluate the overall accuracy of tax filings and identify common errors. While random selection may seem arbitrary, it highlights the importance of maintaining accurate and thorough records to support your tax return.

Scope of an Examination

The scope of an IRS examination varies depending on the issues identified. The goal is to verify the accuracy of your return. Examinations may focus on specific items, such as income or deductions, or involve a broader review of your financial activities. The IRS prioritizes cases where discrepancies or unusual patterns suggest a higher likelihood of errors or non-compliance.

Audits can occur through correspondence, office visits, or field audits. Correspondence audits, the most common type, require additional documentation to substantiate specific items on your return. Office audits involve meeting with an IRS agent, while field audits occur at your business or home. Each type requires different levels of preparation and documentation, making it important to understand the requirements of your particular case.

During the examination, the IRS reviews the documentation you provide to determine if adjustments to your return are necessary. This may involve evaluating financial records such as bank statements, receipts, and invoices to ensure your reported figures align with your actual financial activities. The IRS may also use external data to verify your return’s accuracy.

Documentation Requests

When the IRS begins an examination, it requests additional documentation to support the figures reported on your return. These requests typically include financial records like bank statements, invoices, and receipts. Providing clear and organized documentation can help the process go more smoothly.

For example, if business expenses are under review, the IRS may require receipts and invoices that justify the deductions claimed, such as utility bills or lease agreements. Similarly, if charitable contributions are being examined, acknowledgment letters from recipient organizations may be requested.

The IRS may also seek information about income sources not listed on standard tax forms, such as rental income or freelance work. Maintaining comprehensive records of all income streams, including payment confirmations or detailed spreadsheets, is essential. This level of organization not only helps address IRS inquiries but also reduces the risk of penalties or interest charges.

Correspondence From the IRS

When the IRS initiates an examination, it typically contacts taxpayers through formal correspondence. This initial letter outlines the specific aspects of your return under review and provides deadlines for submitting requested documentation. Reading this communication carefully is critical, as it establishes the expectations for the examination process.

The letter may also reference specific sections of the Internal Revenue Code or Treasury Regulations that pertain to the items under review, offering insight into the legal framework guiding the examination. For example, the IRS may cite rules requiring taxpayers to maintain adequate records to substantiate income, deductions, or credits.

Throughout the process, the IRS may send follow-up notices or letters requesting additional information or providing updates. Responding promptly and proactively to these communications can help resolve issues efficiently and demonstrate your willingness to comply.

Potential Changes to Your Return

At the conclusion of an examination, the IRS may propose adjustments to your tax return. These changes depend on the discrepancies or issues identified during the review. Adjustments might include an increase in taxable income, disallowance of deductions or credits, or reclassification of certain income types. For example, if a claimed business expense does not meet the criteria for being “ordinary and necessary,” the IRS may disallow it, increasing your tax liability.

In some cases, the IRS may identify overpayments or errors that benefit you, such as unclaimed credits or deductions. For instance, if you were eligible for the Earned Income Tax Credit but did not claim it, the IRS might adjust your return to include it, resulting in a refund or reduced liability. However, such outcomes are less common, as examinations typically focus on addressing underreporting or non-compliance.

If changes are made, the IRS will issue a detailed report summarizing the proposed adjustments. This report, known as a Revenue Agent Report (RAR), explains each change and provides a breakdown of any additional taxes, penalties, or interest owed. Taxpayers have the right to contest these findings through the IRS appeals process or, if necessary, pursue litigation in Tax Court. Seeking professional advice can help you navigate this phase effectively.