It’s one of those fears that bog the minds of rich people and even ordinary taxpayers—getting audited by the IRS. But what are the chances that you’ll be audited by the government for your tax returns?
The chances of a tax audit are very low these days. Taxpayers with moderate income levels have a 1 percent chance; while those earning $1 million and up were audited at a 7.5 percent clip.
For companies, the rates are also low. Firms with total assets of less than $10 have a 1 percent chance. Those with assets between $1 and $5 million have a 1.2 percent rate, while firms with asset size of between $5 and $10 million have a 1.9 percent chance of being audited. Even the middle-sized firms or those with assets between $10 and $50 million had a low 6.2 percent chance of being audited.
Sure, the chances of getting a visit from the IRS have shrunk to all-time lows. But that should not be enough reason for you to be complacent. It still pays to know what to do just in case someone from the IRS knocks at your door or you get a letter from the said agency.
Individual Tax Audit
You may not be a millionaire but there are conditions that can increase your risks of being visited by the IRS:
• Being self-employed. There are lots of write-offs that self-employed taxpayers can claim, unlike most employees. These range from a home office to the use of a car and the IRS may have queries about these claims.
• You have itemized deductions that are a lot higher than those of taxpayers with comparable incomes. The tax department will likely flag your return when it notices that there’s a big difference between your write-offs and averages.
Should you get a notification that you are to be audited, don’t panic. Keep in mind that the audit will be done in a professional manner. And if you can give the IRS people the right paperwork then you will be off the hook, so to speak.
You must not also think of ignoring the IRS. Your problem won’t go away. Worse, your interest and penalties will continue to accrue. So the earlier you deal with it, the better.
Types of Audit
There are three types of audits. The more common is the correspondence audit, which is handled by away. According to the Transactional Records Access Clearinghouse, 76 percent of individual audits were of this kind.
These computer-generated correspondences may tell you that there was a mathematical error on your return, or that your return wasn’t the same as the 1099 statements that the IRS received from your bank or broker. In these cases, you simply send the money that you owe.
The letter may also dispute a tax break that you claimed. If you can’t prove that you were correct, then you will have to pay additional taxes.
But what if you’re right? You’ll have to collate the right paperwork then send it back to the IRS through certified days within 30 days of receipt of the letter. You’ll also have to prepare a letter that includes a copy of the correspondence audit plus your reference number.
In some cases, you simply have to go back and get receipts. But there are cases when you can’t do that. Instead, you may have to get a written acknowledgment from the charity that you gave to in order to claim a charitable contribution.
This is a task that you can handle yourself, especially if the issue is simple enough to reply to. You may ask a tax pro to help you out, but you’ll obviously have to pay him or her for the service
If you feel you are deserving of the tax break but you want a stronger case or reply to the IRS, a tax professional can be of significant help. He or he can prepare your return to respond to the agency and give you a better shot at defending your case.
The second type is field audit, which is conducted in person at your home or at IRS offices. However, the chances of an IRS guy dropping by your home are very low these days. The agency is no longer conducting a lot of field audits because these often mean additional expenses.
This type of audit is conducted when the IRS has lots of questions about your return. The agency may also resort to this type of audit when there is a certain write-off that is difficult to handle by mail.
The field audit in an IRS office shouldn’t last more than four hours. However there will likely be a follow-up visit, or the agency would require you to pass additional paperwork.
The last type is the ‘random’ audit. Among the three types of audits, this is the least likely that the IRS will conduct. You have a very slim chance of being selected for this audit.
But then again, it pays to be prepared.
The random audit is perhaps the most detail-oriented and intrusive of the three types of audit. IRS agents may even ask for your birth certificate and marriage license just to check your filing status.
This is also the type of audit where a professional expert can help you. There’s a good chance that something will happen at the audit that can cause the agency to demand you to pay more. With the help of a pro, you’ll be ready just in case the proverbial can of worms is opened.
Attitude During the Audit
Whether you are going to the IRS office or accompanied by a tax pro, you need to behave professionally during the audit. Don’t become argumentative, and treat the agents with respect.
Be honest and truthful with your answers. But you should also answer straight to the point. Avoid talking too much because the more you talk, the more questions that the agency will have.
You should also come to the office prepared and organized. You don’t want to upset the agent with your messy folder and jumbled receipts.
If you are unable to provide the document the agent is looking for, politely ask if there’s any other documentation that you may provide in lieu of the document. For example, you claimed the business use of a vehicle but couldn’t show receipts for gas. Maybe a calendar of your business meetings may be accepted as a substitute.
You can go through the appeals process if you disagree with the contention of the agent. This is where a tax pro can help you as he or she would be able to handle this step.
So what happens if you have to pay the IRS more money but you don’t have cash? You have three choices—one is to pay with a credit card, although you will have to pay a convenience fee of around 2.35 percent. You can also for an installment agreement or request for a compromise.
Business IRS Audits
Again, the chances of a business getting audited by the IRS have gone down in the past few years. But this still should not give your company a false sense of security.
What are the possible issues that the IRS will look into your company’s tax returns? Here are some of the red flags that should make the IRS agents knock on your door:
1. Net loss in more than two of the past five years.
2. Excessive deductions for travel, business meals, and entertainment
3. High salaries paid to shareholders
4. Shifting income to tax-exempt organizations in a bid to avoid payment of taxes
5. Claiming 100 percent business use of a vehicle
Like in individual tax audits, it is important for a business to be prepared if it has been picked for an audit. There’s a silver lining to being audited, as if the agency’s findings show that there is no change to the tax liability then the business won’t be audited on the same issue for the next year.
Hiring a tax professional is the first step that you need to undertake if your business has been pinpointed by the IRS for auditing. Don’t be anxious in thinking that this will indicate that your business is guilty, after all, the IRS is very much used to this practice. A tax professional can help you through the audit.
You can even sign a power-of-attorney agreement to give your tax professional the legal authority to deal with the IRS directly. This is ideal if you are unsure of what to say and what not to say during the audit. This basically takes you out of the loop and puts your tax professional in.
But there are three things that you, as the business owner, should remember when your business is faced with the prospect of being audited by the IRS:
1. Review the audit letter carefully.
An IRS agent won’t just barge into your door and announce an audit. The agency will send an audit letter to your office informing you that your firm has been picked for the audit.
Be cautious with scammers who will masquerade as the IRS by sending you email messages or leaving phone messages. Those guys will attempt to hack your personal data. The real IRS doesn’t communicate through email or phone.
Once you receive the letter, open it promptly. Read and understand what the IRS needs from you.
If your company doesn’t have a financial adviser, you can hire an accountant or tax professional to help you review the review letter. He or she will also identify the issues that the agency has flagged.
Don’t ignore the letter because the IRS will not go away. Worse, the auditor may become more suspicious and even antagonistic.
2. Organize your records.
The next step is to organize your records. Gather and organize all your business records from the previous tax year even before you meet with the tax professional and IRS auditor.
These records range from receipts and invoices from income and expenses, accounting books and ledgers, bank statements, leases or titles for properties and hard copies of tax-prep data. You should also make sure that you have the specific documents requested by the IRS for review.
3. Answer the questions honestly.
During the audit, the IRS agent will ask you a lot of questions about the information reported on your business tax return. Simply answer the questions of the auditor—no more, no less. Giving any information that you are not required to give may put you in more hot water.
Similar to dealing with individual tax audits, providing unasked-for information may give the auditor more questions to ask. The last thing that you want to happen is for the auditor to uncover more issues about your tax returns. IRS auditors won’t forgive tax debt or mistakes, so any admission that you may have will be used against you.
Be straightforward in replying to the questions. However, don’t manufacture excuses. IRS agents would know if you’re making any.
Also, don’t be antagonistic with the auditor. It would only make things worse for you and your business.
In order to avoid future audits, you should track bank transfers and other financial records aside from receipts. Anything that you cannot explain on the standard IRS form must be explained on paper. Of course, double-check all your calculations before filing your returns.
Aside from keeping proper documentation, you can avoid getting picked for an audit by deducting ordinary and necessary business expenses as allowed by the IRS. So even if your company is chosen for an audit, you have nothing to be afraid of.
Indeed, getting a letter from the IRS informing you that you are to be audited can be very worrisome. But if you know how to deal with tax audits, then you don’t have anything to be afraid of. It also helps to have a tax professional guiding you to be assured that you can respond to whatever audit findings the IRS guys have with you or your business.