How Income Tax Audits Work

You get a letter in the mail, a letter emblazoned with the gut-wrenching acronym, IRS. You say to yourself: "But I filed on time! I paid all my taxes!" That may be, but unfortunately, that doesn't mean you won't be audited.

Yes, it’s nerve-wracking. But income tax audits, like death and taxes themselves, are a fact of life in the United States. The Internal Revenue Service examined close to 1.4 million individual tax returns in 2007, about 1 percent of all individual tax returns [source: CNN]. Compare this to 1.29 million returns examined in 2006, and you see that the IRS is becoming increasingly serious about getting its money [source: Kristof].

An audit is frightening no matter what, but it doesn't have to be inscrutable. And it doesn’t always mean you will owe more money. There is, believe it or not, a method to the madness.

An income tax audit is an examination of a tax return. During an audit, an IRS examiner makes a line-by-line assessment of your tax return. If something doesn't add up correctly or the return contains something unusual, the examiner will point out the mistake or ask you to justify the unusual item. Depending on what the examiner finds, you may owe more tax, or you may be in the clear.

This article takes a look at the different types of audits -- office, field and correspondence. You’ll learn what to do if you get the dreaded audit notice. Finally, you’ll learn about the red flags that could attract the IRS examiners, and get some tips on how you can avoid investigation.

Preparing for Income Tax Audits 

How do you prepare for an income tax audit? It depends on the type: correspondence, field or office.

Correspondence Audit
If the IRS examines one of your returns, the examination will likely take place via mail. The IRS uses correspondence audits to take care of the most common tax return problems, such as missing forms and schedules, illegible entries and mathematical errors.

Your first step is to return the audit notice along with any documentation and explanations the IRS has requested. Such documentation might include:
- home mortgage statements
- tax returns
- receipts
- brokerage statements
- retirement account records
- pay stubs

For example, if the IRS questions whether your business meal deductions are valid, you would include receipts from those meals, as well as any proof that these meals were, indeed, business related.

Field Audit
In a field audit, the examiner visits your home or business to verify the information on your tax return. For example, if you write off a massive amount of printer ink, a field examiner might want to know why you go through so much ink.

Office Audit
In an office audit, you go to an examiner's office. The examiner requires you or your representative -- such as your tax preparer or lawyer -- to bring documentation and information such as receipts, account statements or pay stubs.

At the end of the audit, the examiner will mail you or give you a 30-day letter. This letter consists of a copy of the examination report, an explanation of how the IRS wants to change your tax return to reflect the report's findings, an explanation of your right to appeal and a handy publication called "Your Appeal Rights and How To Prepare a Protest If You Don't Agree."

You have 30 days to respond, so if you're not sure about the IRS's findings and you want to consult a tax professional, don't rush to sign the examination report. If, within 30 days, you find the IRS is correct, indicate you agree and sign the examination report.

If you do not agree, however, you can appeal the findings before the 30 days is up. An appeal, handled by an IRS Appeals Officer, can take a year or longer.

Following the appeal, the IRS sends a 90-day letter, which gives you -- you guessed it -- 90 days to request an escalation to Tax Court, in case you don't agree with the Appeals Officer's findings. Most audits are resolved long before Tax Court comes into the picture.

But before you appeal the findings, it would be in your best interest to ensure that you are 100 percent right, because interest accrues on any unpaid tax from the day you file your return, not the date of your audit. For example, if the IRS audits you for a return you filed two years ago, and it turns out you are in the wrong, you owe the unpaid tax plus interest that has accrued over that two years plus late-payment penalties. As you might imagine, these combined factors can make for a nasty bill.

Avoiding Income Tax Audits

discrepancies. Based on a closely guarded formula, the system assigns each return a score that determines whether or not the IRS will audit you.

Here are some common red flags:
- significant income increase or decrease
- significant deduction-to-income ratio -- say, $80,000 in deductions on a $100,000 income
- business deductions consisting of fancy dinners and pricy trips to the Moulin Rouge
- home-office deductions
- low tip income for workers who traditionally make a lot of money from tips
- income exceeding significant benchmarks, such as $100,000 and $1,000,000
- self-employment
- computational mistakes and typos
- incorrect Social Security number
- incorrect reporting of income, deductions, et cetera.
- late filing without applying for an extension with Form 4868
- not paying your full tax liability without applying for an installment agreement with Form 9465

Obviously you can't avoid an income change if you get a better-paying job. And if you're self-employed, you're self-employed. But you can still do some things to decrease the likelihood you will be targeted for examination:

Keep Good Records: Three years is the statute of limitations on auditing returns that were filed on time. So, theoretically, the IRS could audit you for a return you filed three years ago. If you keep good records, you'll be able to answer any inquiries the IRS might have.

Explain Yourself: If your trip to the bowling alley is a justifiable business expense, include the receipts, a written explanation and any other appropriate documentation with your return. If you think the IRS might be curious, take care of it before they have a chance to ask you about it.

Just Because You Spent Money Doesn't Mean It's a Deduction: Don't go overboard with your deductions, especially if you're self-employed. Also, don't estimate your deductions -- use exact amounts based on receipts.

Beware of Tax Software: Tax software is great for returns at the simpler end of the spectrum. When you start getting into deductions and complex sources of income, consider verifying the accuracy of your return with a tax professional.

Compare: Compare your tax liability to the national average for your occupation. If there's a big difference between your tax liability and the rest of the country's, take another look at your return.

Be Tidy: A sloppy return is sure to get a thorough check by the IRS, especially if the all-important numbers are illegible.

Check and Recheck Your Return: Nip mathematical errors in the bud before you file.

There's no sure way to avoid an income tax audit. In fact, every year the IRS conducts a number of random audits to serve as benchmarks for its examinations. The best things you can do are file on time and pay what you owe. When it comes down to it, punctuality and accuracy are the only things the IRS really wants.