Have you ever received a piece of mail from the IRS? If so, you are familiar with the feelings of fear that follow. What if the letter notifies you of the dreaded: you’re being audited?! If it happens and you’re among the lucky chosen few, just remember:

  • Don’t panic
  • Talk to the auditor only enough to refer him/her to your tax professional
  • Get organized

If you are able to follow these few basic pointers, you should be able to handle this challenge with the least possible stress and interruption.

The chances of being audited by the IRS are relatively low, with percentages increasing as income rises. When you get help from your tax professional, you have someone on your side that has an understanding of the tax law as well as the audit process and can coach you on what to say and do. The overall goal of your professional representative will be to handle the audit in such a manner that your “exposure” is decreased. An experienced representative can serve as a buffer between you and the IRS agent and present your tax reporting in the most favorable light possible.

If you find comfort in understanding the why’s and how’s of the way things work, then knowing what could possibly increase the odds of an IRS audit, the different types of audits, and how you can stay prepared can give you the confidence you need to stay calm during your audit process.

Tax returns can be randomly chosen for an audit, but are most often selected because something stood out during the computer analysis. The IRS does not specifically tell us the reasons behind their selection process, but we do know that the following items have been identified as flags that could increase your chances of unwanted IRS attention.

  • Deductions related to business meals, travel, and entertainment. The IRS measures these deductions using occupational codes and compares a taxpayer’s deductions to what is considered the norm for that particular occupation. They know what’s typical and may question large variances.
  • Mismatched income. The IRS will receive copies of your W-2’s, 1099’s, 1098’s, etc. from other sources. If the amounts on these forms don’t match your reported taxable income, the computer will flag your return and send you a bill.
  • Claiming rental and partnership losses. Questions are often raised concerning active participation in these activities, a classification that allows losses to offset other income if certain requirements are met. The IRS continues to harvest tax adjustments with programs that target these write-offs and may request documentation to prove participation claims.
  • Schedule C and business activities of sole proprietors. The IRS focus is shifting away from auditing regular corporations and more toward small businesses. Auditors will be searching for any unreported income, deductions for personal expenses, or hobby activity losses written off as business losses.
  • Claiming higher-than-average deductions. If the deductions on your tax return, including charitable donations, are disproportionately large compared with your income, the IRS computers may refer your return for human review and possibly a follow-up audit.
  • Excessive cash transactions. Cash transactions over $10,000 must be reported to the IRS by banks and other merchants such as casinos, car dealerships and similar cash businesses. These transactions may be monitored for unreported income.
  • Failure to report foreign bank account assets. The federal government likes to prosecute people who do not report offshore assets. If a foreign financial institution discloses your identity to the US government, you may gain the focus of an IRS auditor.

There are three common types of IRS audits.

  1. Correspondence Audit. A correspondence audit is the simplest, lowest level type of IRS audit. The IRS conducts hundreds of thousands of correspondence audits each year. During this audit, the IRS typically mails the taxpayer a written request for more information or a notice that the taxpayer’s tax return has been changed.
  2. Office Audit. An office audit takes place in an IRS office, where the taxpayer or taxpayer’s representative will have a face-to-face meeting with an IRS auditor. IRS office audits are more complex than correspondence audits, but still pertain to relatively simple tax matters. Office audits often involve common items found on tax returns, such as exemptions, travel and entertainment expenses and casualty losses.These types of audits are occurring less frequently with the IRS relying more on the other two methods discussed.
  3. Field Audit. A field audit is the most comprehensive type of IRS audit. It is generally conducted in the taxpayer’s home, place of business, or accountant’s office. A field audit can involve complex tax matters and are often more difficult to resolve. The IRS tries to audit returns as soon as possible after they are filed, normally within two years of filing.

The IRS can include returns filed within the last three years in an audit. Even with the odds in your favor for the probability of an audit, it is still a good idea to take precautions now in case your number ever comes up.

  • Keep receipts to back up your deductions.You should have receipts for all charitable donations, business expenses, and medical expenses.
  • If you have business meals and entertainment, be sure to keep detailed records regarding the amount, the place, the people attending, and the purpose of the event.
  • If you ever receive a W-2, 1099, or other informational form that shows an incorrect amount, confirm that the issuer of the document files a corrected form directly with the IRS.

An IRS audit is never a pleasant experience, but can often be dealt with swiftly and painlessly. If you have reported and documented the items in your return correctly and have expert representation on your side, your audit will end with the best possible outcome, and probably with no additional tax.