What every taxpayer should know regarding types of IRS audits and common issues that can trigger audit.
An audit is an investigation into a tax return of an individual, business, estate or trust. The IRS uses this process to determine if the information provided in the tax return is correct. This article discusses three types of audits and several common audit triggers.
Types of IRS Audits
This is the most common type of audit and also the easiest in terms of what is required and the length of time involved. Usually the IRS will send a request for supporting documentation to prove deductions, exemptions, proof of dependents, proof of charitable donations or other documentation to corroborate a specific part of the return. This is the least stressful form of audit for the taxpayer and usually sending in the requested paperwork is enough to satisfy the IRS. It is strongly advised that you seek the help of an experienced tax attorney to prepare your reply to the IRS correspondence audit and to ensure the documentation you send is exactly what is needed. As long as a response is made within the timeframe and the documentation enclosed satisfies the proof needed by the IRS, the audit is complete. This type of audit is most commonly utilized for individual tax returns, where there are perhaps one or two simple issues the IRS wants you to substantiate.
An invitation to appear at an IRS office to conduct an office audit is a serious matter. It is important you do not attend the office audit without your tax attorney. Being asked to an office audit means the IRS is counting on the possibility that you owe additional taxes. It is essential that you seek the advice of an experienced tax attorney to accompany you to the IRS office audit to protect your rights and to use their knowledge and experience to assist you in finding ways to reduce or eliminate any additional taxes.
A field audit is the most serious form of audit and involves an IRS Auditor coming to your place of business to thoroughly audit your records. If the IRS finds that your business has inaccurately reported income and evaded paying the correct tax, the consequences could result in heavy penalties, additional taxes and possible prison time. It is of utmost importance to engage the services of an experienced tax attorney to be present while the IRS auditor is at your place of business.
Below is a summary of common audit triggers
Large amount of charitable donations
The IRS looks closely at the receipts and proof of your charitable donations. If your charitable donations are more than 3% of your income, the IRS will scrutinize your documentation. Make sure you have receipts, cancelled checks, and appraisals for all donations to substantiate your claim for deductions.
Failing to report part of your income
The IRS already knows what is on your W-2 and 1099s in terms of income. If you do not report your income accurately on your tax return, this will likely trigger an audit. You will receive a W-2 from your full-time job, but may also receive 1099s for freelance work you do on the side, as well as other forms of miscellaneous income, in all cases you must report all of your income from all sources.
Large losses on Schedule C, or many years of losses on Schedule C
If you are self-employed, and report your income on a Schedule C, you will report either a profit or a loss. If your return shows a very large business loss on a Schedule C, or if you have a history of several years of losses on your Schedule C, this will likely attract IRS attention.
The reason behind this is that the IRS likes to see a profit at least two out of five years to consider a business legitimate. If there are five years of losses reported on a Schedule C, the IRS will likely audit to see if ‘hobby’ would be a better description. This is important because taxpayers are required to report any income earned from a hobby, but tax payers generally cannot deduct losses.
For example, a Professional Photographer with his own business, clients, advertisements, portfolio etc., can claim as a business expense the purchase of a camera. Whereas, a doctor who enjoys taking photographs during his weekend hikes cannot claim a new camera as a business expense.
Claiming too many business expenses
In addition to the business/hobby issue just discussed, reporting too many losses can also cause the IRS to question how your business is staying solvent. If you report many personal expenses through your business without it being a true necessary business expense (in order for your net profit to decrease and therefore your tax liability to decrease) the IRS will scrutinize your records during an audit.
Unfortunately, even if you do everything right, there is always a small (less than 1%) chance that your return will be randomly selected for an audit.
If you do receive an audit notice from the IRS, it does not need to be the start of a stressful and difficult time for you and your family, or your business. You will likely benefit from an experienced tax attorney’s advice and direction with the protection of the attorney client privilege.