Tax Audits Explained (Not As Scary As You Think)
In movies, tax audits are always scary. Big, burly, intimidating men in dark suits and glasses. Over-sized clipboards. The sound of pens furiously scratching paper. Handcuffs. You know the deal.
But are tax audit visits really that frightening in real life? Not so. In fact, only 1% of all taxpayers even experience an audit. Of those, about 20% ever result in a face-to-face encounter with the IRS. Most inquires, fortunately, are resolved through correspondence. Take a look below at our guide to tax audits.
Though audits have increased slightly in recent years, chances of being audited are still low. In 2008, the IRS audited about 1.4 million tax returns out of a total of 140 million.
Most audits are conducted via mail. Last year, 78% dealt with the IRS via correspondence, while 22% came in for an in-person exam. CNN reports that correspondence audits are cheaper for the IRS–and, according to Georgetown professor Thomas Cooke, people tend to take action as soon as they get a letter (perhaps hoping to delay any personal visits.) However, don’t assume the IRS is correct. Research the issue the IRS is challenging. In many cases, the IRS may be unable to match information reported to them versus what you reported. Fortunately, it may be something as simple as providing additional information or an explanation to meet their requirements.
Correspondence audits usually require you to provide information (or evidence) about very specific claims made on your tax report–or a check for unpaid taxes. On the other hand, an “office audit” is slightly more involved and more intimidating–you’ll have to go into an IRS office. A third option, a”field audit”, is typically a fuller examination, and is conducted at the home or business office where you work.
The IRS will let you know which documents are needed beforehand. If your documents supports the original return, you shouldn’t have a problem–the audit is “no change.” If the auditor finds a discrepancy (and you agree), you can sign the documents and pay any taxes owed. You can choose to disagree with the auditor’s findings, in which case you can appeal the decision later. As a general rule, it is best not to offer the IRS agent any information beyond what is specifically needed. Otherwise, you could generate additional questions from the IRS.
You Might Get Audited If…
You Claim Losses. If you own a business, you’ll need to first prove your business is legitimate (i.e., your intention is to earn a profit) and not a hobby. Claiming anywhere from a $5000 to a $10,000 loss is usually a red flag; if you get audited, you’ll need to provide statements related to loans, business bank accounts, business licenses, and income.
Claiming rental losses can also be a red flag for the IRS, since you can usually deduct only a limited amount of losses–and still must meet certain conditions. If “passive” loss allowance is higher than $25,000, expect a notice from the IRS.
You Claim Uncommon Deductions. If your deductions are unusually large, or are somehow related to home office expenses, your chances of getting audited are much higher than average. This is because some taxpayers have historically attempted to deduct non-business expenses (like home telephone service, living room or bedroom space, etc.) for tax purposes. Same goes for extravagant business deductions related to meals or entertainment.
Charitable Contributions. Claim a large charitable deduction and you’re likely to be on the IRS hot list. That’s because, in the past, documentation requirements for charitable contributions has been less stringent than it is today.
You Have a Cash Business. The IRS knows that businesses that deal much in cash transactions–like taxi driving, hair salons, etc. -can easily conceal income. The IRS has actually fashioned a new guide to cash-intensive businesses for agents, so be meticulous with your documentation and reporting.
If you have evidence of your claims for all taxes, you should be fine.