It is perfectly normal to feel worried or scared when the Internal Revenue Service (IRS) has chosen you for a tax audit. The IRS auditors will comb through your income tax return, receipts, business books, and other financial records. You may feel you are going to be hauled off to a tax court or, worse, spend years in prison. Before you start panicking, make sure you are prepared for anything with regard to taxes, including an audit. Read on to learn more about how a tax audit works and what you can do to reduce your chances of being audited.
In this article:
Tax Audit | Your Basic Questions Answered
Why Are Certain Tax Returns Selected for Review?
There are two ways the IRS selects returns for a tax audit. These are review systems and random sampling.
One of these review systems is the Discriminant Function System (DIF) score. The IRS calculates the DIF using a scoring model designed to indicate a tax return is likely to need changes. It will compare your return with similar ones that have come through in the past 3 to 5 years. The more variation there is between your return and others, the higher your score is likely to be.
There is another scoring model the IRS uses to select returns for review. It is UIDIF or Unreported Income score. It puts a rate of probability of you not reporting your full taxable income.
If your return comes back with a high DIF or UIDIF score, the IRS is more likely to subject it to further review. What can potentially result in a high score?
- A substantially higher reported income than normal compared to the previous year
- A substantially lower reported income than normal compared to the previous year
- Claims for excessive business deductions and expenses
- Failure to report 1099 on your form
It is also possible to get flagged even if your income tax return does not meet the points above. The IRS does pull a random sampling to check for any discrepancy.
What Can You Expect from the Tax Audit Process?
If your tax return was worthy of further review, you will receive a CP05 Notice informing you of the tax audit. This form will notify you of the review and the items they are going to look at. The most common ones are the following:
- Income
- Withholding amounts
- Claimed tax credits
- Income reported on a Schedule C
- Social Security benefits withholding
- Household help claims
Receiving the notice does not mean you have to reply. You cannot do anything to stop the process at this point. The notice only serves as a legal notification of what is occurring. The taxing authorities will make the verification attempts on their own and will contact you if they need further information. They may also reach out to third parties.
To be proactive, it may be beneficial to gather any necessary documents in case you need to provide more information. If your return is flagged and you are expecting a return, you will not receive it until the process is complete. More importantly, if you owe money such as back taxes or tax underpayment, you need to make sure you pay by the tax deadline to avoid incurring interests and penalties.
The length of the process will largely depend on how much information they have to verify. If 45 days pass without any more correspondence, you may want to follow up to check the status.
What Are the Possible Outcomes from a Review?
The results of the tax audit will primarily depend on what they found. There are several outcomes that can occur. Of course, the best-case scenario is the IRS will find nothing wrong with your tax return.
Though this is a possible outcome, it is prudent to prepare yourself for the worst-case scenario. If the IRS found there are more taxes owed, it could end up being a mild concern or a major one. If the underpayment is less than a thousand dollars, you will simply have to pay the difference with a small penalty.
It is a bigger problem if the tax liability is off by several thousand dollars. If you cannot pay it all at once, you can apply to have it paid in an installment agreement. However, it may incur penalties and interests until you pay the amount in full.
Note you may not be able to have multiple IRS installment loans at once. Further, these loans can span several years, so if you use one this year, you will not likely qualify in the next.
Probably the worst situation is to undergo a full-scale tax audit. It is at this point an auditor will come out to review your tax returns for up to 3 years (even 6 in some cases). The tax professional will investigate every portion of your return including income, taxes paid, write-offs, and expenses.
How Likely Is a Tax Audit?
Hearing you are subject to a tax audit can be unnerving, but here is some good news. Few taxpayers will get flagged for a review. Even fewer will undergo an audit. Your likelihood of an audit is even less if your income is on the lower end:
- 1% chance of tax audit for those making less than $200,000
- 3% chance of tax audit for those making over $200,000 but less than a million
- 6% chance of tax audit for making a million dollars or more
The bottom line is, when it comes to the IRS, it is always best to play it safe. Always be prepared for a tax audit. Acquaint yourself with a tax lawyer. You can also significantly reduce the chances of a review by knowing the tax law or working closely with an expert in tax preparation. You can also use good tax software if you want to do it DIY.
Have you experienced a tax audit? Share your experience below!
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