The IRS only audited 230,340 tax returns in 2019, accounting for 0.31 percent of all incoming tax returns for that tax year. In contrast, the IRS audited roughly 1.11 percent of all returns as recently as 2010, and audits were even more common. Yet despite historically low auditing rates, the IRS has dramatically expanded its auditing operations and aims to pick up the pace. This means taxpayers and businesses – especially larger ones – should beware of the IRS audit and its meaning.
Does that mean you should worry? No, not really. IRS audits are still relatively rare (the IRS only employed 82,000 workers in 2021 versus 94,000 in 2010), but they’re also routine and painless. Nevertheless, it pays to be prepared – and if you want to know what might await you if the IRS decides to launch an investigation into your taxes, you’re in luck. The agency provides plenty of information to taxpayers on what IRS audits entail, down to industry specifics.
What Is an IRS Audit?
An IRS audit or an IRS tax investigation is a human-operated look at your tax returns, related returns, and financial information. The IRS will ask for documents supporting deductions and claims you’ve made and will cross-reference the information you’ve provided in your returns and elsewhere with data provided by banks and other entities through respective information returns.
While a human auditor is responsible for going over your tax info, it’s typically an algorithm that initially picks up the error or discrepancy. The IRS employs different computer algorithms to sift through taxpayer information and red flags, such as inconsistent or questionable deductions or math errors. Some issues, like minor math errors, are often automatically fixed by the IRS – if they result in an overdue balance, you’re sent a bill, and that’s that.
But other errors may require the attention of a human being. Most IRS audits occur over the phone or by mail. These are called correspondence audits, and they’re little more than a back-and-forth of questions and information over phone and mail. Once the IRS is satisfied and has answered their questions, they will decide what should happen with your tax account – resulting in either declaration of underpayment, overpayment, or no changes.
If you are underpaid, the IRS will send a bill. If you overpaid, you get a tax refund. Quite simple. But in many cases, it can still be nerve-wracking. It’s no secret that taxes are complicated, and the tax challenges of individuals usually pale in comparison to those of an operating business. It’s not a crime to have made a mistake. But it can become an expensive error.
Types of IRS Audits
We’ve mentioned correspondence audits, but the IRS also conducts two other types of audits:
- Field audits are conducted on the field and involve a visit to your home or place of business.
- Office audits are conducted at the nearest IRS office, and the taxpayer is requested to come around with their supporting documents.
An audit always begins with a physical letter sent to the targeted taxpayer informing them of their upcoming audit. Instructions and contact information will be provided with said letter. Suppose you’re a business owner, and an audit is held regarding your operation. The auditor in question will likely refer to the official IRS Audit Techniques Guides (ATGs) to assist them throughout their investigation. These ATGs are available to taxpayers for research and reading through the IRS’s website.
Understanding IRS Audit Techniques Guides (ATGs)
IRS Audit Techniques Guides are written for auditors, not taxpayers. Still, they effectively serve as an auditor’s playbook in an industry audit, so you can learn a lot from giving an ATG a quick skim through as a business owner. All ATGs serve as a primer to help auditors better understand the target industry’s structure, terminology, and typical business practices. They also serve as guidance on how to examine a business’ income, evaluate given evidence, and help business owners understand what the IRS is looking for and how to best prepare and organize taxes and financials to ensure a smooth, quick, and painless audit.
For example, an ATG on new automobile dealerships will inform and instruct auditors on the typical business and operations structure of a dealership, the nature in which returns might be filled out to represent multiple joint entities cooperating through the dealership (such as a management entity, an insurance entity, and a land-owning entity). These ATGs help auditors watch for meaningful financial connections and tax considerations unique to the industry or require a more profound investigation due to common mistakes and/or loopholes.
What Audit Techniques Guides Say About Your Auditing Process
A typical ATG will give you as a business owner an idea of what an IRS auditor will be looking for, what they intend to probe and ask in their initial interview, and what documents they’re likely to request throughout the audit. ATGs often include flowcharts for questions and answers, giving you insight into how a discussion might go and what you should expect and prepare. IRS auditors are still human and will use their best judgment and experience for auditing your operation.
While ATGs serve as playbooks and guides, your auditor might not follow the ATG to the letter, especially if they have had their own experiences with other businesses in your industry. IRS audits may also go differently if your business is being investigated not because of discrepancies, but concerning a more extensive investigation into a completely different entity or person, especially in suspected tax fraud or criminal activity. Working with a tax professional is still your best bet for receiving actionable representation and advice, especially concerning cooperating with the IRS and keeping audits painless and straightforward.