In recent years, the IRS has audited only about 0.5% of individual income tax returns. Their audit choices have been more high net worth returns and larger companies with more tax issues. But based on recent tax legislation, President Biden and some legislators have targeted more IRS funding to help close the tax gap — the difference between what taxpayers owe and what they actually pay. In fact, several federal spending proposals rely on revenue recovered from unpaid taxes to minimize new tax increases.
It is still not clear how the IRS will use these resources. But the IRS has stated that historically, audit risk rises with income and that taxpayers with incomes higher than $10 million are much more likely to be audited than other taxpayers. The IRS has data from third-party information that helps them match smaller tax returns, so they tend to avoid auditing data they have already. Regardless of the source of your income, the size of your income and your tax bracket, be prepared to act if you receive a letter from the IRS. Your preparation and careful response may determine whether the process is drawn-out and frustrating or relatively swift and painless.
Need to know the process
The IRS generally contacts taxpayers about an audit via regular U.S. mail or with a phone call and follow-up letter. The IRS never uses email to notify taxpayers of being selected for audits. If you do receive an email, it is likely not from the IRS and may be an attempt to defraud you.
The upper right corner of the envelope you receive should include a number specifying the reason for the correspondence. For example, Notice Number CP05A indicates that the IRS is examining your income tax return and requires a response with documentation.
Your return may have been chosen for examination for many reasons. It could be chosen randomly, it could be a problem in accepting your tax return or it could be because the IRS needs additional information from you. Since your tax return does not include all details of your personal taxes, it is important not to assume what is the specific reason for being chosen. Even if the IRS suspects mistakes or misstatements, you should first review if you have properly prepared and filed the tax return and then respond while remaining calm and cooperative.
Need to respond appropriately
Most IRS audit notices include a deadline by which you are required to respond or schedule an appointment. Since it takes time to begin gathering the information and preparing a response, you will need to manage the next steps appropriately. This may include invoices, canceled checks and receipts, as well as your tax return for the year(s) in question. If you maintain a file of your documentation, make duplicates of any documents you will need to provide to the IRS, so that you can maintain a clear record of your communication and avoid losing your only copy of a record.
Although it is critical to provide all of the information requested, you should avoid volunteering additional records, such as tax returns from years falling outside the audit’s scope. Many returns have items that create a pattern for many years and adding more information may prompt more questions and create a more extensive audit. The IRS often has three years from the tax filing date to begin an audit, and if any of these years are available, the audit could be expanded to more years.
If a tax preparer helped with your return, it may help to contact that person. Your professional will likely know what information should be provided and how to answer interview questions appropriately, without inviting further investigation. The advisor also can review any documents you are asked to sign — before you agree on sensitive issues. This can be very valuable whether you are responding in person or via letter. Finally, having an expert on your side to handle the process can limit the time and stress of the audit.
Need to evaluate the cost of owing money
Most taxpayers assume that there are errors and the process will end with them owing money. In fact, audits often conclude with a tax liability remaining the same. And in some cases, the IRS ends its examination concluding that it owes money to the taxpayer, which may include interest. But if you do have proposed adjustments, how much should you expect to pay? The final answer varies widely. Keep in mind that, in addition to the extra tax owed, you may be assessed interest and penalties if the basis and size of the adjustment resulted from large and obvious mistakes.
Although many audited taxpayers agree to any changes proposed by the IRS, you may disagree on the basis for the audit results. There could be a unique story of facts in your favor, or the tax law may be unclear on your situation. If so, you can appeal the decision through the IRS’s Appeals Office which will offer a second opinion on the results. Or, you can take your case to Tax Court, which offers additional rights to appeal and the proper procedures to do so. Again, the cost of challenging the results may be more than the benefit of accepting the final results.
Consider the scenarios and options
Of course, many audits are not complicated and can be settled outside of Appeals or Tax Court. Many are correspondence audits in which you mail requested documents back to the IRS and respond to any follow-up questions. It is best to determine how much help is needed to work through the process and whether you should accept or disagree with the results.
If you have any questions or concerns, please contact your ORBA Advisor or Tom Kosinski at (312) 670-7444 to review your personal tax situation. Visit ORBA.com to learn more about our Wealth Management Services.