Only about 1% of filers per year get audited, but it can be a nerve-wracking, even frightening experience for the taxpayer. Your clients, whether individuals or businesses, are going to need your guidance as they go through an audit.
The IRS’s definition of an audit is “a review/examination of an organization’s or individual’s accounts and financial information to ensure information is being reported correctly, according to the tax laws, to verify the amount of tax reported is accurate.” Thus, the purpose of an audit is to resolve discrepancies.
As a tax expert, you most likely catch any discrepancies in your clients’ tax filings, decreasing the likelihood of being audited. This is an important benefit that taxpayers have when they have their taxes prepared by you. However, your work is only as good as the information you receive, and the IRS may believe they have reason to audit your client. Or you may receive a frantic call from a non-client who has just received an audit notice and is suddenly desperate for the help of an expert.
Either way, you can lead your clients through their audits confidently and effectively.
Types of Audits
There are three types of audits: correspondence audit, office audit, or field audit. The correspondence audit is by far the most common, consisting of a letter sent by the IRS to the taxpayer requesting certain additional documentation to solve a discrepancy they are seeing. The taxpayer usually has 30 days to respond.
An office or field audit is much more involved and could potentially result in a much larger adjustment than the correspondence audit. In the office audit, the taxpayer and any representatives go to the IRS office with the requested documentation. In the field audit, the IRS shows up at the taxpayer’s door or place of business and does a more extensive review.
The CP2000 notice, or underreporter inquiry, is not technically an audit, but can still cause a taxpayer anxiety. The IRS sends nearly 4,000,000 per year, to approximately 2.5% of all filers. These are triggered when the IRS has received documentation from a third party of payouts to a taxpayer but the taxpayer has not included them on his or her tax return.
Likely audit red flags
Items that frequently cause the IRS to take a second look include:
- Mismatched information, such as social security number, capital gains/losses, W-2 or 1099 earnings left off the tax return
- Very high or very low income
- Unusually large charitable donations, medical expenses, gambling losses
- Foreign assets or foreign cash, especially if it is not included on the tax return
- Significant number of tax credits
- Business expense deductions, 100% business use of a vehicle, home office deductions
- Business losses
- Claiming a hobby as a business
- Trading or dealing in cryptocurrency
- Businesses that deal heavily in cash transactions, such as laundromats, landscaping, and restaurants due to difficulty in verifying income
- Taking an early payout from IRA or 401(k)
- Rounded numbers or math errors
- Not filing a return
How you can help
If a client comes to you with a correspondence letter, you should be able to help the client provide the documentation requested within the timeframe. However, since the IRS has up to 3 years to audit a tax return, taxpayers sometimes discard important documents prematurely. This can cause a problem. If the client does not have the requested documentation, you may be able to help him or her provide similar documents that can support the taxpayer’s filing and satisfy the IRS request.
If the IRS has requested an office visit or field visit with your client, your help will be invaluable. You have the depth of understanding of the entire tax process and can communicate with the IRS officers at a technical level that your client cannot. You can also judge, based on your experience and the types of documentation the IRS is requesting, what they are looking for and the kinds of questions they will ask.
A field or office audit can result in a significant increase in taxes because the IRS will be looking for income that should have been taxed but was not. They will look at bank statements for large deposits, withdrawals, and transfers – anything that looks like it may have been an attempt to hide income. They will assume large deposits were taxable income unless the taxpayer can prove they were non-taxable, such as gifts or nontaxable sale of assets. They will want to see supporting documentation for major deductions such as medical expenses.
Prepare your client for the IRS audit by collecting all supporting documentation requested in the Information Document Requests (IDR). If possible, have the client pull together examples from previous years – for instance, in the case of major charitable donations, provide evidence of several years of charitable donations to show a history of giving.
Review with your client the kinds of questions the IRS is likely to ask and how to respond. Also, go over with your client the kinds of questions that you will field. Go with your client to the audit and be the financial expert who answers most of the questions.
While nearly 90% of audits result in a change in the tax return, your presence could help limit the impact on your client and prevent inaccurate and unwarranted taxes or penalties.