What is the Purpose of an IRS Audit?

An IRS audit can be a stressful time. Many audits are conducted through correspondence examinations involving less complex return issues, like erroneous earned income tax credit reporting or filing status.

These audits can be resolved by sending in the requested documentation, like receipts or canceled checks.

The Internal Revenue Service (IRS) is motivated to audit returns for two main reasons: 

First, the Taxpayer Act of 1998 mandated changes in customer service solutions. 

Second, the IRS Examination Division is motivated to audit returns of businesses in specific industries.

A tax audit is a thorough review of a taxpayer’s reported income and deductions by IRS tax professionals. These reviews can be conducted by correspondence, office, or field. Audits can be a time-consuming and stressful process for taxpayers and businesses. However, there are certain things you can do to make your tax audit experience a smooth one.

The IRS is authorized to correct math and clerical errors on returns and recalculate liability using software programs. The agency also has the authority to use third-party documents to validate the accuracy of a return or refund. These processes do not require a formal examination of the return and can reduce the number of IRS employees needed to perform an exam.

In recent years, the IRS has been focusing on areas of high risk and compliance issues. These areas include high-income, high-wealth taxpayers; cash-intensive businesses; transfer pricing; research and development credits; cryptocurrencies; and partnerships and flow-through entities. As a result, the IRS’s overall audit numbers have fallen. However, some of the decline was due to budgetary constraints that required reducing the number of field employees and focusing on specific industries.

Despite falling audit numbers, the IRS’s enforcement revenue from examinations has remained stable, largely because of an increase in the number of delinquent accounts that have been identified and collected by the agency’s field collection unit. In addition, a recent Supreme Court case has expanded the type of information the IRS can request from third parties without serving a summons or notifying the taxpayer.

In addition, the IRS is increasingly relying on automated processes to check return information and identify errors before they become a problem for taxpayers. These automated processes do not produce as much enforcement revenue, but they can be effective at identifying errors in the return that may have caused the taxpayer to file incorrectly.

The final determination of whether additional taxes are owed is the responsibility of the revenue agent who conducts the examination of the return. The examiner will typically recommend an additional amount of tax to be paid by the taxpayer. If the taxpayer disagrees with the recommendation, the taxpayer has the right to appeal the decision within the IRS and in federal courts.

The IRS can determine how long the audit will take based on the issue(s) selected for examination. To help ensure that the process flows smoothly, it is important for the issue team to work collaboratively with the taxpayer or their representative to establish issue timelines. This will help ensure that all requests for information are fulfilled in a timely manner and that the case is resolved effectively.

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Third, the IRS is motivated to audit returns of individuals.

The IRS uses a variety of methods to check the accuracy of returns. These methods do not require an employee to examine the return and include the correction of mathematical errors and matching information from third-party sources against returns. The IRS also checks for fraudulent activity and identifies underreporting of income. The IRS can then use this data to determine which tax returns to audit and what to look for on those audited returns.

Individuals who have lower incomes have a higher risk of being selected for an audit. However, the IRS has made no plans to increase the number of audits of individuals in recent years. The agency cites continued resource constraints as the reason.

The agency does have plans to increase audits of small businesses, though. These audits will focus on those with high inventories and more complex financial structures. This is because the IRS believes these individuals have a greater chance of underreporting their income and are more likely to use deductions and credits that they are not entitled to.

If your return is selected for an audit, the IRS will send you a letter that details what specific items they want to review. Some audits are handled solely through the mail, while others are conducted at an IRS office or your place of business. Depending on the complexity of your return, it may be appropriate to have the examination conducted via correspondence, which would mean that the agent only reviews the written questions submitted with the original audit letter.

Most audits are conducted at the IRS offices, but field audits can be performed at your home or at the place of business of your business. In either case, the revenue agent who conducts the audit will ask to review paperwork and other evidence proving your return’s accuracy. The agent will also discuss with you any potential changes that need to be made, and you will have the right to appeal if you disagree with their decisions.

In addition, the IRS has a set budget that it must follow each year, and the agency must make sure that the money it spends is well spent. The IRS is required to spend a certain percentage of its budget on each of its three lines of business: compliance, collection, and enforcement.

The IRS spends most of its budget on compliance, which is the work done to ensure that all taxpayers are filing their taxes correctly and paying the amount they owe. The other two lines of business—collection and enforcement—have smaller budgets. In recent years, the IRS has focused more on collecting overdue tax payments and transferring delinquent accounts to private collection agencies. This has resulted in a reduction of cases opened and more cases that have been closed.

Fourth, the IRS is motivated to audit returns of businesses that are cash intensive.

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The IRS uses a variety of methods to identify returns that could be suspect. They may use computerized software that compares your return to a “norm” of similar returns and flags it for review. They also look at returns filed by high-net-worth taxpayers and those who report income from foreign entities and assets. In addition, the IRS is often tipped off by third parties that have concerns about a tax return. The IRS can then send you a letter asking for further explanation or verification of your return.

The odds of an audit increase if you run a cash-intensive business. This is because the IRS watches these businesses for signs that they might be skimming some of their revenue by underreporting profits. The IRS has a specific Audit Technique Guide for Cash Intensive Businesses that spells out how an auditor will approach an examination of this type of business.

As a general rule, the IRS will examine your business’s profit ratio compared to the expected profit ratio for your industry. This is the most common way that a business can trigger an IRS audit. If your ratio is much lower than what is typical, the IRS will become suspicious.

The IRS often requests financial records from you and your accountant to verify your profit figures. The IRS will then make an informed decision about whether they want to pursue the audit further or not. If they decide to proceed with the audit, they will then use their resources to gather evidence and question you. They can summon third parties like banks and even search through government databases such as the FinCEN asset locator or immigration files.

Once they have all the information they need, the IRS will determine if you owe more money. They can issue a notice of assessment that will detail the changes they have determined to be necessary. The IRS will then offer you two options: Agree or disagree. If you agree with the proposed changes, your audit will end, and the matter will be resolved. If you disagree, your dispute will be decided by the IRS appeals board or the court of taxation in your jurisdiction.

It is important to understand the purpose of an IRS audit so that you can avoid becoming the subject of one. Avoiding certain behaviors can significantly decrease your chances of being audited and potentially avoid a costly experience. Additionally, it is helpful to know that the results of an audit are not final and that you have the right to representation and a hearing before any disagreements are settled. You also have the right to appeal any disagreements within the IRS or to the United States Tax Court.