Jeremy Springer

Apr 185 min read

Tax Audits

With tax just in our rearview mirror, we wanted to talk tax audits. While they are rare, they do still occur for different reasons. Some audits are only through the mail while other audits may be in person. Here are some of the things we think you should know should you ever receive that letter in the mail.

Person holding magnifying glass looking at financial reports

Representation

Individual taxpayers who are under audit by the IRS may attend the audit in person without any assistance from a tax professional. However, this can be a dangerous mistake. Although not officially stated, it is the job of an IRS Revenue Agent to conduct an audit with an eye toward finding additional tax owed. With so many gray areas in tax law, and considering the tax code’s complexity, an individual who chooses to go it alone is a sitting duck. With extensive tax education and experience, the examiner can take a position finding additional tax due on the return. Without the necessary knowledge, the typical individual is powerless to refute the agent’s rationale.

Selection of Returns for Examination

Search for Unreported Income

The IRS performs matching functions to reconcile information reported on Forms 1099 and W-2 with information reported on your return. If income reported by you does not meet or exceed amounts reported to the IRS, you will receive either a bill for tax on the difference or an audit notice.

Worker Reclassification Efforts

The IRS conducts employment audits to determine whether workers classified as independent contractors are in fact employees.

Schedule C (Form 1040), Profit or Loss From Business

Issues associated with sole proprietorships are common audit triggers. The IRS has several approaches to achieve an increase in income tax, as well as the assessment of

self-employment tax.

Unreported income. There is a relatively high potential for unreported income from cash transactions with sole proprietorships. The IRS will examine your bank records to detect deposits that are unaccounted for, compare revenue and expenses of similar businesses, and in some cases will perform a “lifestyle” audit to reconstruct income based on changes in the sole proprietor’s net worth.
Losses. Significant losses reported on Schedule C (Form 1040), or losses continuing over two or more years, may increase the chance of audit. If the IRS is successful in reclassifying an activity as a hobby instead of a for-profit business, losses will be disallowed.
Bartering. The fair market value of products and services received through bartering can be considered business income if the products or services rendered are associated with the sole proprietorship. If the sole proprietor trades through a barter exchange program, the program will issue Form 1099-B, Proceeds from Broker and Barter Exchange Transactions.

Audit Procedures

Examination by Mail

Notice CP 2057. A CP 2057 notice informs you that there appears to be an income discrepancy on your return. The notice instructs you to review the return and file an amended return to correct the information, if necessary.

Notice CP 2000. A CP 2000 notice from the IRS proposes changes to your tax return based on information the IRS has received from third party sources (i.e. Forms W-2, 1099-INT, 1099-MISC, etc.) that the IRS believes has not been reported on your return. You typically have 30 days to respond to the IRS with one of three options.

To agree with all the proposals.
To partially agree with the changes.
To dispute all the changes proposed by the IRS.

You are allowed to sign an authorization that enables another party to represent you in connection with the Notice CP 2000. The authorization is part of Notice CP 2000, and a

separate power of attorney is not required.

Field Audit (In-Person)

The revenue agent will send a letter to you requesting that you phone the agent. At that time, the date, location, and agenda for the first meeting will be set. You have the right to request that the examination take place at a reasonable time and place that is convenient for both you and the IRS. You also have the right to be represented by a tax professional at this meeting.

Audit Strategy

The best way to prepare for an audit is to put oneself into the auditor’s shoes. Take the perspective that you are looking for anything possible to increase the tax liability on the return. This is an area where a qualified tax preparer can be invaluable.

Ask yourself tough questions and be prepared to support any questionable deductions. Make sure any issue raised during an audit is something that has already been considered. If the pre-audit function is performed properly, the actual audit will be more comfortable, and you will be prepared for any negative adjustments.

When conducting an audit, the IRS will ask you to present documents to substantiate the income, deductions, and credits claimed on your tax return. The documentation should be organized by year and the type of income or deduction.

IRS Videos

The IRS has created a video web page to assist taxpayers with various questions. Go to the IRS website at www.irsvideos.gov.

Appeals

If you disagree with the IRS proposed changes, you can appeal the results of the examination in one of the following ways.

For examinations taking place in an IRS office, you can request an immediate meeting with the examiner’s supervisor.
Use mediation services offered by the IRS.
Appeal to the local IRS Appeals Office.

Take It Seriously

Any comments made to an IRS employee that could be interpreted as a threat against the employee will be taken seriously and fully investigated. Do not joke around with IRS employees during an examination.

Repeat Examinations

If a return was examined for the same items in either of the two previous years, and no change was proposed to the tax liability, contact the IRS immediately and the examination will likely be discontinued. This policy is in accordance with IRC section 7605(b), which states that no taxpayer shall be subjected to “unnecessary examinations.”

End of an Audit

No Change Letter

If the return is accepted as filed, the IRS will issue a “no change letter,” and no further action is required.

30-Day Letter

In an unagreed case, the IRS will issue a “30-day letter.” You are given the option of agreeing with the proposed changes and also given information about protesting and appealing the results of the audit.

90-Day Letter

If you do not respond to the 30-day letter, the IRS will issue a statutory Notice of Deficiency which allows you 90 days to file a petition to the Tax Court or pay the tax and file a claim for refund.

Legal Disclaimer: This post contains general information for taxpayers and should not be relied upon as the only source of authority. Taxpayers should seek professional tax advice for more information. This information was current at time of posting; we are not responsible for updating this or any blog post/article for subsequent changes in the law or its interpretation.