Receiving a notice of audit from the IRS can be very unsettling. Even if you can prove that your return was prepared correctly, dealing with an IRS audit is frustrating and time-consuming.
Every year the IRS randomly selects a small percentage of individual and small business tax returns for audit. The odds of your return being selected for a random audit are very low. However, the probability of your return being audited due to a “red flag” is much greater. Therefore, you should carefully document all common red flags that might trigger an audit before you file your taxes with the IRS. You should not avoid taking all legitimate deductions for fear of being audited.
Taxpayers reporting business income and expenses on Schedule C are more likely to be audited then other individuals. The higher your self-employment income the more likely you are to be audited. If your Schedule C income exceeds $1 million, your chance of audit is ten times greater than if your self-employment income is less than $25,000. Your risk of audit might be reduced by incorporating your business. You should carefully consider all the implications of incorporation before making that decision. Comparing the corporate tax rate with your personal tax rate is important when deciding between a C-corporation and an S-Corporation.
The following factors may cause your individual or small business tax return to be selected for IRS audit:
- Income reported to IRS but not on your return. If the IRS received Form 1099s reporting income paid to you by individuals or entities and your return does not reflect all of the income reported, you will hear from the IRS.
- Deductions higher than the norm. If your business expenses or personal deductions are more than the average amount claimed for your income level or type of business, your tax return might be scrutinized and possibly selected for IRS audit. However, you can reduce the risk of audit by including with your return documentation of the deduction and possibly an explanation as to why an expense was reasonable and necessary.
- Categories being scrutinized by IRS. The IRS has identified certain types of expenses, deductions and credits that are frequently exaggerated or claimed without justification. Deductions targeted by IRS may change from year-to-year. Below are some of the items the IRS may question:
- Automobile, travel and entertainment expenses
- Office-in-home deduction
- Itemized deductions such as mortgage interest and charitable contributions
- Earned Income Tax Credit
- Filing Status and Dependency Exemptions
- Casualty and Net Operating Losses
- Tax credits
- Rental Activities
Types of Audits:
- Service Center Audits are generally handled by mail. These audits are usually a result of document mismatches, mathematical errors, or omitted schedules.
- Correspondence Audits are usually a result of questionable deductions or credits. The IRS sends a series of notices questioning specific items and requesting a written explanation or documentation from the taxpayer.
- Office Audits which are handled at a local IRS office. The taxpayer is asked to appear at the office on a particular date and is given a list of specific documents to bring to the audit.
- Field Audits which are conducted at the taxpayer’s home or place of business. The IRS will send a notice with a proposed date and time for the audit and a description of the exact information and documentation the taxpayer must have available at the time of the audit.
If you receive a notice of audit from the IRS you should respond without delay. Ideally you will have a relationship with a tax preparer that will help you to deal with the IRS. Most audits can be handled by mail. If the IRS requires you to attend an audit in person, you should be accompanied or represented by your tax professional. Your preparer can accompany you to the audit and answer questions about how your return was prepared. However, we recommend that you choose an Enrolled Agent, CPA or attorney. He/she may communicate directly with the IRS on your behalf and ensure that your rights are protected during the audit. You will be required to sign a Form 2848, Power of Attorney for tax matters to give the professional your permission to represent you during the audit process.
IRS CIRCULAR 230 NOTICE: Title 31, Code of Federal Regulations, Part 10 requires us to notify you that any tax advice included in this communication is not intended or written to be used, and it cannot be used by the taxpayer, or any other person or entity, for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.