How IRS Audits Work

Audit anxiety is something nearly every taxpayer has in common.  But, have you ever considered how IRS audits actually work?

The IRS processes millions of tax returns each year that are never subject to additional examination or audit. Obviously, it is in your best interest to report things accurately and hope to stay off the IRS’s radar. Unfortunately, that isn’t always possible. Being selected for an audit does not inherently imply guilt or deception, and can happen to anyone that files a tax return.

I thought this would be a good topic of discussion as we go into the 2023 tax year. The IRS announced they are hiring 5,000 new agents in 2023, so this is especially relevant. Therefore, I will discuss how audits work, how returns are selected for audit, different types of audits, and ways to keep yourself protected if you are audited.

First, let’s go over some interesting statistics found in the 2021 IRS Service Data Book.

Statistics

The chances of being audited are pretty low. The IRS had 78,661 full time employees in 2021, and IRS employees dedicated to enforcement are only around 45%. Contrast this with the 167,915,264 individual 1040 tax returns filed in 2021. Consequently, the IRS has an estimated one IRS enforcement agent for every 4,800 individual 1040 returns filed, an extremely low ratio of agents to returns.

These enforcement agents don’t just look at 1040’s, either. Let’s add the 12,209,623 business entity returns filed in 2021 to our numerator. That equals roughly one IRS enforcement agent for every 5,200 returns. I won’t bother factoring estate, excise, payroll, tax exempt, and trust tax returns into the calculation, you get the idea.

Return Selection 

Most tax returns go through an automated, electronic system called the “Discriminant Function,” or “DIF” for short. The IRS calculates the DIF score by weighting and adding together return characteristics. The higher the DIF score, the higher the potential for audit. Every 1040 return gets a DIF score. Additionally, S Corp and C Corp returns with assets less than $10,000,000 get DIF scores. The IRS uses other techniques to select returns for audits as well.

The IRS matches information in their files to information reported on your tax return. For example, a taxpayer receives a 1099-INT after cashing in a savings bond. If the taxpayer fails to report the interest or reports a different amount than what the 1099-INT shows, chances are this return will get selected for an audit.

Confidential informants can tip off the IRS, resulting in return selection. So can related party transactions with a taxpayer already under examination.

Certain schedules are high risk and can trigger scrutiny from the IRS. Form 8283 Non-cash Contributions, Form 8275 Disclosure statement, and Form 8082 Notice of Inconsistent Treatment are a few examples that can trigger a closer look at your return.

Per the 2021 IRS Data Book, here are some current trends the IRS is looking closely into:

• Too many round numbers and deductions that offset large income items
• FBAR reporting issues related to perceived under-reporting of foreign income
• Virtual currency
• Passive vs. non-passive flow through income
• Real estate professional positions on rental real estate
• Worker classification – employee vs. contractor
• Matching source documents to returns, as mentioned above

But not all audits are equal. The intensity varies. So lets discuss the different types and cover some details of how IRS audits work.

Correspondence Examination/Audit

Correspondence audits are the most common, and there is a good chance you may have already had one. Have you ever received an IRS notice for your tax return? Maybe you failed to make estimated tax payments and received a notice asking you to pay interest. That is a correspondence audit, and usually not a big deal.

The IRS conducts these audits entirely through the mail. The IRS will make an adjustment or correction to a return, indicate the change, and calculate additional tax or refund due. Then, the taxpayer can either pay the additional tax or collect their additional refund if they agree with the adjustment.

Taxpayers can request more information or disagree with the change or correction and propose their own. The taxpayer should support their position with additional supporting documentation in their IRS response letter.

Sometimes taxpayers avoid these letters and take no action; not a recommended strategy. The IRS will send a second notice of deficiency letter, often referred to as a 30 day letter, requesting payment, when no action is taken by the taxpayer.

If no response is sent within 30 days, the IRS issues a Statutory Notice of Deficiency, and if the taxpayer still disagrees, they can file an appeal with the tax court.

Office Examination/Audit

A Tax Compliance Officer (TCO) conducts this type of audit in person at an IRS office to resolve issues too complex to resolve by mail. Typical issues include large itemized deductions, travel expenses, and misclassified income from rents and royalties.

The TCO will send the taxpayer a letter requesting an appointment and the type of documentation they need to bring to substantiate data reported on the tax return.

At the appointment, the TCO will collect oral testimony and physical documentation and will make one of three determinations; 1.) No change 2.) Deficiency 3.) Over-assessment.

Finally, lets discuss the third type of audit, the Field Audit.

Field Examination/Audit

A TCO conducts this type of audit at the location where the original books, records, and source documents are maintained, generally the taxpayer’s home or place of business. As you can probably guess, they are the least common type of audit. 21% of 2021 audits were field audits, per the 2021 IRS Service Data Book.

Spending the day in an office with an IRS agent is nobody’s idea of fun, however, these audits can produce more favorable results for the taxpayer than the other audit types.

Markedly, here are a few tips if you find yourself in a field audit:

• Be polite and friendly
• Know your taxpayer rights
• Avoid offering more information than needed
• Be honest
• Have your records organized and easily accessible
• Never leave the examiner alone
• Negotiate your positions

Appeals

A taxpayer can appeal if no agreement is reached. You must submit a formal written protest if the total amount owed exceeds $25,000, or the appeal is for a partnership, S Corp, or tax exempt organization.

There is no IRS form for a written appeal, but, it needs to include the following information:

• Statement the taxpayer wants to appeal the examiner’s findings to the appeals office
• Taxpayer’s name, address, and phone number
• A copy of the letter showing the proposed changes
• Tax periods involved
• Schedule of adjustments the taxpayer disagrees with
• Statement of fact supporting the taxpayer’s position
• Statement outlining the law the taxpayer relies on
• Declaration under penalties of perjury attesting the statement of facts as true and accurate

Protection

Now lets discuss some different expenses and how to ensure they are substantiated.

Trade or Business Expenses

Before taking a deduction, you want to ensure your activity rises to the level of a trade or business.  26 U.S. Code § 162 allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business.  A taxpayer must continuously and regularly be involved in the activity for the primary purpose of making a profit.

The regulations provide a list of relevant factors when considering if the activity rises to the level of a trade or business, including:

• Expertise of the taxpayer
• Time and effort expended on the activity
• History of income and losses with respect to the activity
• Whether elements of personal pleasure or recreation are involved in the activity
• Manner in which the taxpayer carried on the activity

Example

Lets explore this a bit more and use myself as an example.  I like fixing up cars, which inevitably ends up with me having more money in them than I can sell them for.  I also have a job as a CPA and know this car hobby is not a money making endeavor.  There is no profit motive, no history of success, and is done purely for personal pleasure.  It surely does not rise to the level of a trade or business, therefore I cannot report the activity on my 1040 tax return and claim a loss that offsets my CPA income.

The scenario is probably different if I am working on other people’s cars for money on the side.  I would need to report the income, and I would certainly have expenses (tools, supplies, etc.) that are legitimate business deductions.

In summary, be careful not to take losses and deductions on an activity the IRS would classify as a hobby and not a business.

Travel Expenses

You need to substantiate business expenses, clearly, but this is especially true with travel expenses. Travel expenses aren’t as straight forward as say, a rent payment to the landlord of a retail store, so extra diligence must be used when deducting travel.

To qualify for a deduction, travel expenses must be:

• Reasonable and necessary
• Incurred while traveling “away from home”
• Directly related to the conduct of the taxpayer’s trade or business

Three factors are used to determine a taxpayer’s “tax home:”

1. Whether there existed a business connection to the location of the home
2. Were duplicate living expenses incurred while traveling and while maintaining the tax home?
3. Whether personal connections exist to the tax home

Commuting to the office is not a qualified travel expense. And if your place of employment is somewhere other than your residence, and you decide not to move your residence to your work location, living and travel expenses getting to your job are not deductible either.

Mixed purpose travel gets murky too. It must be primarily related to the taxpayer’s trade or business to be deductible, with time spent on business being the most relevant factor. If you have business seminars in Hawaii for four days, and you stay for two additional vacation days, that probably counts. Reverse the business and personal time, that probably doesn’t count.  And there must be a bona-fide business purpose for a spouse’s travel expenses to be deductible.

Charitable Contributions

If you generally have enough deductions to itemize, chances are you have probably taken a charitable contribution deduction.  And you want to have very good records to substantiation the contribution.

For cash contributions of $250 or less, you need to have one of the following:

• Canceled check
• Bank or credit card statement
• Receipt from the organization
• Paystub if contributed through a payroll deduction

Cash contributions greater than $250 should, ideally, be substantiated with a receipt from the organization detailing the dollar amount, date, and whether any goods or services were provided to the donor.

Worker Classification Audits

The last topic I want to discuss is worker classification audits. Employers have a financial incentive to misclassify employees as independent contractors because costs and record keeping is lower.  Workers have an incentive to be classified as independent contractors because they can deduct expenses not available to employees.

The IRS uses a three-factor test to determine if a person is an employee or a contractor:

1. Behavior Control – Does the employer provide training to the worker? The more training provided, the more control the employer exerts over the worker.
2. Financial Control – Key factors include the workers investment in the services they provide, other services they make available to the market, and the opportunity for their own profit with respect to their services.
3. Relationship of Parties – Relationship factors include the extent to which either party can terminate the relationship, the party’s contractual relationship, and the employer providing, or not providing, benefits typically provided to an employee.

Misclassification of a worker as an independent contractor can have large consequences to the employer.  The employer may end up liable for payroll taxes on all open tax years, federal income tax that should have been withheld from the workers paychecks, and any state income taxes that should have been paid on the worker.  Consequently, only one or two worker misclassifications could lead to thousands of dollars of tax owed.

Final Thoughts

The goal of this blogpost was to (hopefully) relieve some anxiety by covering how IRS audits work and what you can expect if you ever find yourself in an audit situation. You should not feel bad if it happens to you. But, you want to be smart and methodical on how your respond to and deal with the IRS.

Good record keeping, honesty, and a little bit of knowledge will go along way on keeping yourself protected.

We have some additional posts on IRS audit prevention tips, real estate professional audit troubles, and surviving short term rental audits that contain great information if you want even more detail.