Taxpayers in general have about a 1% chance of receiving an IRS audit each year. You beat the odds and your tax return has been selected for an audit. What does this mean and what do you do?
What is an IRS Tax Audit?
An IRS tax audit means that the IRS is examining your tax return carefully for the accuracy with intent to verify the correctness. Your return may have been selected (i) based on the IRS’s computer program that scores returns based on certain red flags the IRS has identified (e.g., Schedule C filers, cash basis businesses, excessive deductions), (ii) based on information received from third-party documentation, such as Forms 1099 and W-2 that do not match the information reported on your return, or (iii) to address questionable treatment of an item and to study the behavior of similar taxpayers in that market segment in handling the tax issue.
It is helpful to understand the statute of limitation under which the IRS audit is conducted. In most cases, the IRS has 3 years from the date the tax return is filed to assess any additional tax. Typically, this means the IRS will issue an audit notice 12 to 18 months after the tax return is filed and have 1 to 2 years to complete the audit. If the audit is not completed within the 3 year period and the IRS does not timely assess additional tax liability, the taxpayer is generally not liable for the additional tax.
However, if the taxpayer (is found to have) underreported income on the tax return by 25% or more, then the IRS has 6 years to audit and assess tax deficiency from the date the return is filed. In the case of fraud, the IRS has unlimited time period to audit the tax return.
The Audit Process
The audit may be conducted by mail, in taxpayer’s place of business or preferably at its representative’s office (to minimize the IRS’s access to documents and information), or in the IRS offices. The IRS will typically request information and documents to review, and may ask to interview the taxpayer. The law requires you to retain records used to prepare your tax return, and generally you should keep them for three years from the date the tax return was filed.
During the audit process, taxpayers have certain rights: (i) the right to professional and courteous treatment by the IRS employees, (ii) right to privacy and confidentiality about tax matters, (iii) right to know why the IRS is asking for information, how the IRS will use it and what will happen if the requested information is not provided, (iv) a right to representation by oneself or an authorized representative, and (v) right to appeal.
The audit may conclude with: (i) no change to the return because all of the items under review were substantiated, (ii) taxpayer agreeing with the IRS’s proposed changes to the tax liability, or (iii) taxpayer disagreeing with the IRS’s proposed changes.
Protesting IRS Proposed Changes
If you agree with the IRS proposed changes, you can sign the examination report, and if money is owed, several payment options may be available.
If you disagree with the IRS findings based on the tax law, a conference with a manager may be requested for further review of the issue. If an agreement cannot be reached with the examiner’s supervisor, the examiner will forward your case for processing and you will receive a letter (known as a 30-day letter) notifying you of your right to appeal the proposed changes within 30 days.
A formal written protest within 30-days is usually required to appeal the case to the IRS Appeals division. The IRS Appeals division is separate and independent of the IRS Examination division which conducts the audit, and is designed to settle most disputes without going to court. If is important to respond timely to the 30-day letter if you want to appeal your case.
If you do not respond to the 30-day letter (or if you do not reach an agreement with the IRS Appeals Officer), the IRS will send you a letter (known as a 90-day letter), notifying you of your right to file a petition with the United States Tax Court within 90 days. Alternatively, you may take your case to the United States Court of Federal Claims or the United States District Courts.
Taking your Case to Court
Generally, the Tax Court hears your case before any tax has been assessed and paid. If you do not file your Tax Court petition on time, the proposed tax will be assessed, a bill will be sent to you and you have to pay your taxes or collection can proceed.
The District Court and the Court of Federal Claims hear tax cases only after you have paid the tax and filed a claim for a credit or refund with the IRS on Form 1040X. Generally, you must file a claim for a credit or refund within 3 years from the date you filed your original return or 2 years from the date you paid the tax, whichever is later.
If the IRS rejects your claim, you can file suit for a credit or refund in the District Court or in the Court of Federal Claims within 2 years from the date IRS rejects your claim. You can also file suit for credit or refund if the IRS has not delivered a decision within 6 months since you filed a claim.
The IRS Appeals Office will normally consider any case petitioned to the United State Tax Court for settlement before the Tax Court hears the case. You may be able to recover reasonable litigation or administrative expenses to defend your position with the IRS if you are the prevailing party, exhaust all administrative remedies within the IRS, your net worth is below certain limit and other requirements are met.
If you owe any additional taxes, you must pay interest on the additional tax, and interest is generally calculated from the due date of your return to the date of your payment. Interest, however, may be suspended or abated under certain specific circumstances.
If you owe any additional taxes, various civil tax penalty provisions could apply, including the 20% accuracy related penalty on the total understatement of tax, failure to file penalty, failure to pay penalty, and civil fraud penalties equal to 75% of any federal tax due to fraud, plus interest on penalties. Worst case, possible criminal charges (misdemeanors and felonies) could arise in applicable cases.
When faced with an IRS (or a state) audit, the goal is to limit the scope of the auditor’s review and limit your financial impact, and settle any disputes as early as possible during the examination or appeals process. The first thing you should do is consult a tax counsel who can assist you, especially if you have complex or sensitive issues, since settlements of disputes often involve legal analysis of the tax law and an in-depth understanding of the tax procedure. You should consult a tax counsel if you have potentially sensitive tax issues that might involve criminal tax matters.