No one wants an audit letter from the IRS, but if you do end up getting audited, don’t panic! Stephanie Taylor Christensen speaks with tax experts and fellow Grownups who survived the process.
Think tax audits are reserved only for big corporations, the wealthy, the self-employed—or the dishonest? Think again. According to the IRS, about 1.2 million taxpayers were audited in fiscal year 2014. The fact is federal tax audits become a reality for about 1 percent of Americans each year—not including the audit activities initiated by states and local municipalities.
We spoke to some tax experts and an “average Jane” who got audited in her early 30s to find out what really happens when you’re the subject of a tax audit.
How a Tax Audit Begins
The mass media made much of the IRS’ 2015 budget cuts, announcing that fewer auditor resources meant a lower chance of being audited. While Steven M. Packer, CPA and senior manager of Duane Morris LLP’s tax accounting group says budget cuts did make the IRS a leaner organization, it still targets taxpayers who fall into certain high-risk groups. These include individual taxpayers with adjusted gross income (AGI) in excess of $200,000, taxpayers who make income from means others than basic wages (like contract or freelance work), taxpayers who take large meal and entertainment deductions, and those who claim excessive business auto use relative to their income.
Common targets for audits include self-employed taxpayers who report low income but have large business deductions, those who operate primarily cash-based businesses, and taxpayers who claim high non-cash charitable deductions and cash contributions that are higher than the average, relative to their income.
But how do you know when deductions and claims are too large or too excessive? “The closer you bridge the gap between your income and deductions/expenses to $0, the more likely an audit will happen,” explains Sean Chi, lead tax attorney at Clean Slate Tax, a firm that specializes in taxpayer resolutions. “For example, a sole proprietor that claims to lose money five years in a row begs the question: ‘How are you still in business?’”
Amanda, a married mother living in Chicago, was shocked to receive an IRS audit letter back in 2010 questioning the validity of her charitable contributions. At the time, Amanda was single, 32, and living in New York City. She made a decent salary—but certainly wasn’t “rich.” She had consulted a tax preparer each tax season, and thought she did everything right. How was she flagged for an audit?
Packer explains that the IRS primarily uses two methods for identifying which returns to audit. One is a computer program called the Discriminant Index Function (DIF). It scores tax returns using mathematical formulas. “The higher the DIF score, the higher the chances of an audit that will be profitable to the IRS,” says Packer.
The second method is the Market Segment Specialization Program (MSSP). “It focuses on a taxpayer’s industry rather than the type of return the taxpayer files, the amount of gross income reported, or the ratio of deductions to income,” says Packer. “These ‘secret formulas’ are programmed to focus on what the IRS considers the most profitable audit prospects.”
How You’re Notified of an Audit (and What You Should Do)
If you’re the subject of an audit, you’ll receive a letter in the mail (from the tax agency conducting the audit) notifying you that items in your tax return(s) are being questioned and why. Some letters specify which type(s) of documentation you need to provide (which may include past tax returns, W-2s, and similar proof of income or expenses), and a deadline. The letter includes a phone number to call for more information.
Receiving an audit letter can be alarming—and it’s not a matter to handle on your own. “You need a professional who can facilitate conversations between you and the auditor. Ultimately, it will save you more than it costs,” says former IRS agent Howard Rosen. “Remember that the IRS is trying to collect money,” adds Packer. “They can use a simple request as an opening to investigate other areas of your tax return.”
Though Amanda hired an accountant to work with the auditors, the entire audit process took more than a year. “I spent at least 10 hours digging back through old receipts and credit card statements, and reviewed [the claim in question] with my accountant. Once we returned the information they requested, I received two more letters indicating they [the IRS] needed more time. I finally received a letter from them indicating what I owed,” says Amanda.
What You Owe, What Can Be Negotiated—and How to Pay
Though Rosen says how much you owe depends on the nature of your audit, some things can be negotiated. “Penalties generally cannot be negotiated away—but interest charges could. If there are multiple items in question, there may be opportunities to negotiate smaller issues in exchange for resolution of bigger ones.”
Chi adds that negotiating power also depends on what you can prove. “If the documentation you have is sufficient to convince the IRS that you have some or all of an expense, they’ll adjust their audit.” Thanks to her ability to provide documentation for some of her charitable contributions, Amanda ultimately paid the IRS about $7,000—which was less than what they originally claimed she owed.
If you don’t have the cash available to pay what you owe in full at the conclusion of the audit, Rosen says a monthly payment plan is usually the preferred method of collection. “The auditors are in this to make money,” explains Rosen. So while they legally can garnish wages or seize assets, they prefer not to. (Those extremes cost them a lot of time and money, too.)
What Happens After the Audit?
Since she was audited, does Amanda now have a special place on the IRS’ “secret watch list”? The answer depends on who you ask—and the nature of the audit. Rosen says it’s unlikely, but Packer and Chi say it’s possible.
But being audited has forever changed Melissa’s outlook on her responsibility as a taxpayer. “I was surprised to get audited at all—but learned that you can’t round or estimate when it comes to the IRS. If you don’t have a receipt, don’t claim it.”
She also learned the importance of choosing your financial professionals carefully. “I use a different accountant from the one I worked with during the year in question. If the person working on your tax return tells you ‘Don’t worry, they won’t ever look at it’—be very careful,” she says.
Stephanie Taylor Christensen is a former financial services marketer turned freelance writer who covers personal finance, career, health, and small business news. She is the owner of Om for Mom prenatal yoga in Columbus, Ohio. Connect with her on Twitter.
Any third-party resources or websites referenced above are not under Society of Grownups control. Society of Grownups cannot guarantee and are not responsible for the accuracy of the resources, websites, or any products or services available through such resources or websites.
While Society of Grownups hopes the information is useful, it’s only intended to provide general education. It’s not legal, tax, or investment advice, and may not apply or be useful to your specific financial situation. If you need recommendations geared to your personal financial situation, schedule time with a financial planner.