The Tax Audit Process: Procedure, Rules & Guidelines for IRS to Audit

audit procedureTax audits can be conducted by the IRS and by State departments of taxation. The following information is based upon IRS tax audits, just keep in mind that most state audit processes and procedures are fairly similar to the IRS. The purpose of a tax audit is to verify that the tax reported is correct. Most of the time when the IRS selects your return for an audit it is because statistically there is a problem based upon the numbers you provided. Being selected doesn't always mean there is a problem, sometimes you may actually be due a refund after the audit or the IRS accepts your tax return as is.

How Tax Returns Are Selected for an Audit

The IRS uses many different factors when selecting which returns it is going to audit. The majority of tax audits are determined by computers. The IRS has several different computer systems that do various types of analysis on returns that do statistical analysis to score tax returns based on their likelihood of being correct. The IRS also chooses audits based off of other non computer related analysis as well, all methods are described below.

  1. The Discriminant Function System (DIF): The IRS has a computer program that is called the Discriminant Function System that gives each tax return a score. This score is called the DIF score. The score is a number that statistically determines the likelihood of the tax return being accurate. The higher the number that is assigned to the tax return, the higher the likelihood of that tax return being audited. The IRS does not share the details of how exactly their system works, but it is believed that there are several hundred variables that are weighed out and it is believed that deductions and exemptions claimed carry the biggest weights.
  2. The Unreported Income Discriminant Function (UIDIF): This is a second computer program that is used by the IRS that looks at different factors than the DIF system. The purpose of this program is to rate the return on it's potential to have unreported income. This system scores people based upon expense and income ratio. Mainly what this is trying to determine is if an individual is spending more money than they make and therefore likely have other income that they are not reporting to the IRS. It does happen sometimes that individuals do have low income years and this triggers an audit for them, but most of the time this can be explained easily to an auditor.
  3. The Information Returns Processing System (IRP): This is a third computer system used by the IRS that stores massive amounts of data received from third parties that are required to report taxpayer income, such as employers, banks, brokerage firms, social security administration and other institutions that are required to report information to the IRS on taxpayers. For example, your employer is required to report to the IRS how much they paid their employees throughout the year. The IRS will then run their matching system to make sure the individual taxpayer reported everything that was already provided to the IRS. Using this system the IRS can find individuals that have likely under reported their income and they will follow up with an audit.
  4. Incriminating Documents Turned Over to IRS: In rare cases tax returns will be selected to be audited based upon information that was obtained by the IRS in the effort to identify participants in tax avoidance transactions. Sometimes the IRS will get the courts to order information from the promoter to be handed over to the IRS. This information can point out individuals that were involved with the promoters tax avoidance schemes.
  5. Audits of Related Entities: If the IRS audited another tax return and that return involved transactions with other taxpayers such as investors or business partners and that return had a problem and it is likely that other individuals that are related to that entity/individual then it is a possiblility that the IRS will then select those related tax returns to audit.

Types of Audits Once Selected

Once the IRS determines that it would like to follow through and get more information about your tax return, they will send a letter stating that your return has been selected for an audit. Below are the 3 different examination methods used by the IRS.

  1. Correspondence Audit: This is the most common type of audit and is done by mail. The IRS will normally request specific documentation to support particular items on the tax return.
  2. Field Audit: This is when the IRS wants to come to your home, place of business, or your tax professionals office to perform the audit. This is the least common form of audit and is only used if the individual or business being audited earned well over $100K.
  3. Office Audit: This is when you are required to go to an IRS office to meet with an IRS auditor. The IRS will determine the time and the particular documents that it would like you to bring for support.

What Happens After an Audit

After the audit you will either be handed or mailed IRS Form 4549, which is the IRS examination report and will show the proposed changes to tax liability. This form will provide a clear explanation of any adjustments made. The report will either state that you have had no changes or you are due a refund (no action required on your part, you won!) or it will state the changes that have been made and you owe more taxes plus interest and penalties. You have two options once you receive this, you can approve their findings or you can choose to disagree with their findings, each described in more detail below.

  • Approve of Audit Findings: If you agree with the proposed changes then you should sign and return a copy of the report with IRS Form 870. IRS Form 870 is the Consent to Proposed Tax Adjustment. Once you sign the form you are agreeing that you have a tax deficiency and the additional tax penalties and interest that are listed on your examination report as well. If you owe more taxes than you can afford to pay in full then you can request to pay through a payment plan. The payment plan you use will be determined by how much money you owe and how much you can afford to pay monthly.
  • Disapprove of Audit Findings: If you don't approve of the findings in the examination report then you will have 30 days to do any of the following:
    • Mail in additional documents you would like them to consider,
    • Request a discussion on the findings with the examiner (you can do this and submit additional information to be considered).
    • Discuss your case with the group manager or senior manager
    • Request an appeal: If you do not agree with the proposed changes and you were not able to clear up the disagreement with the examiner than an appeal could be a good possibility.

You will have 30 days to consider the proposed adjustments after receiving the examination report. If you do not respond within 30 days then the IRS will send a notice that your case is considered not agreed and if you will have only 30 more days to file for an appeal or the IRS findings will become final.