For most taxpayers, the thought of being audited can cause them to break into a cold sweat. Should that really be your reaction though? An audit is not something to fear and isn’t nearly as painful as you might believe, as long as you follow the rules. In reality, your chances of being audited are extremely low, with the odds for most people being about 1%.
It’s important to understand that the IRS does not have the resources to pursue the massive amount of known taxes that are incorrectly reported or not paid. In 2005, the total inventory of taxes that were known and not paid, was estimated at $345 billion. Because of the huge gap that exists between taxpayers and the number of IRS enforcement agents, the IRS has adopted the use of sophisticated algorithms that analyze our tax returns. If your tax return looks funny, the odds of you being audited increase dramatically.
For example:
If your return has extremely large deductions in relation to your income, you are more likely to be audited. Example: If you made $30,000 in gross income, and you claim $25,000 in deductions.
Claiming certain deductions that are notoriously abused by taxpayers can increase your chances for audit. (I.E. Vehicle expenses, personal expense that aren’t actually related to business but you claim that like they are- like netflix.) However, if you follow the rules and are claiming those deductions honestly and correctly, you should not avoid them.
A business that shows recurring losses are more likely to be audited, as the IRS may suspect that you are making more money than is being reported.
Deducting expenses that are odd or out of place for your business or trade can increase your chances as well. For example: An IT consultant claiming steel toed boots or a CPA claiming a yacht for advertising purposes.
One of 2 types of audit will occur, if you are selected for audit. The first, an in-person audit, occurs when an IRS agent comes to your home or place of business to review your records. Generally this happens when the IRS is investigating more than just one or two deductions.
First of all, like any job, there is a main objective that needs to be accomplished, and it just so happens that an IRS auditor’s job is to make the government money. Don’t misunderstand that as them being tasked with creating reasons or ways to make extra money from taxpayers. They are simply supposed to find the money that is already owed to the government. Whether you accidentally deducted an expense incorrectly, forgot to list an income correctly, or actively sought to deceive the IRS, their job is to find and fix those mistakes.
For any in-person audit, IRS agents have to review three issues:
Income: They will want to see your bank statements, records of the sale of assets, documents relating to alimony, pensions, prizes you received, and your state and federal tax refunds.
Past returns: Agents will examine whether you filed prior years returns on time, or at all, and make adjustments if necessary. Agents abide by a statute of limitations of 3 years for your past returns.
Penalties: They will inquire whether you have been assessed tax penalties in the past, and if penalties should be imposed as a result of the current audit.
The burden of proof lies on the taxpayer to legitimize any deduction that comes into question. That is why it is so important to keep detailed and accessible records. Any deduction that you can’t produce adequate proof for, will be disallowed by the IRS agent. In reality though, you should never try to handle an audit by yourself. You have the right to representation and we recommend you have either your CPA or an attorney represent you. It makes your life and the IRS agent’s life easier, as well as guaranteeing the best protection you can get.
The second form of audit is called a correspondence audit. This type of audit is so tame, many people get through it without ever realizing they were being audited. For a correspondence audit, the IRS sends a written request for the taxpayer to provide additional information about a specific item or issue on your tax return.
At the end of the day, depending on what was revealed by your records or lack thereof, there are only 3 possible outcomes to an IRS audit.
The IRS is satisfied with the documentation and explanations you provided, and they don’t change anything on your tax return
The IRS finds you owe more taxes and suggests changes to your tax return, of which, you can agree to or challenge the agent’s assessment.
If you agree to the changes, you will sign an examination report and make a payment arrangement with the IRS.
If you challenge the assessment, a conference with an IRS manager is scheduled to further review your case.
The IRS finds you actually paid too much taxes, and issues you a refund.
That last outcome might sound outlandish, so let’s look at an example below, of an actual correspondence audit that resulted in a refund.
As you can see, the IRS has no intention of keeping money that doesn’t belong to the government. The IRS really is reasonable, and the agents have no intention of disallowing any deductions that you have provided sufficient proof for. If you follow the rules set forth by the IRS when doing your taxes and you keep clear, detailed, and accessible records, you will get through an IRS audit unscathed.
At Independent Contractor Tax Advisors, not only do we help you maximize your tax savings, we help you keep organized and advise you on how to properly deduct expenses. If you want an entire tax team on your side, please contact us today for a free tax consultation!
If you want to learn more about what makes an expense deductible, with information on common deductions, Click Here.
For more information on keeping detailed records, Click Here.
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