IRS Audit: What to Know, What to Do in 2024
Taxpayers are selected for an IRS audit for a variety of reasons.
Some taxpayers are chosen due to a document mismatch, such as a return that is missing 1099’s or W-2’s. The IRS computers usually spot missing documents based on the social security number (SSN) or employer identification number (EIN) on the document.
Others taxpayers are selected for audit due to statistical irregularities, such as unusually high charitable contributions or business expenses. Think of the luxury car parked in the driveway of taxpayer who declares $35,000 in income per year.
Sometimes IRS audits are based on a general geographic area (like a city) or particular industry (such as cash-based businesses, like nail salons) that the IRS wishes to examine in more detail.
Or, it could be that someone filed a whistleblower claim against the taxpayer. Whistleblower claims occur when someone informs on a person or business to the IRS, suggesting tax fraud or other tax irregularities.
Read on to learn the audit basics – what to know and what to do.
IRS Audit Letter
An IRS audit letter or notice announces the start of the audit. This letter, or a subsequent letter, may ask for further information about details on the tax return, such as itemized deductions, eligibility for credits or filing status. Often the letter will ask for documentation, such as copies of receipts. Or, the letter may ask about unreported income. These letters are called Information Document Request Letters (IDR).
The IRS audit letter usually comes by certified mail. The IRS will not contact the taxpayer by telephone to initiate an audit. The IRS will also not contact the taxpayer by email.
The letter will identify the name of the taxpayer, including social security number, the tax form (for example, Form 1040) and the tax year in question. It will also identify the type of audit that the IRS is conducting.
Open the letter right away. Attempt to answer the letter or hire a CPA or Enrolled Agent who is experienced with IRS tax audits to answer the letter for you. Do not delay. The letter will have a response deadline. Make sure to respond to the IRS audit letter prior to the deadline.
Types of IRS Audits
Field audits: Filed audits are performed at the taxpayer’s home, place of business, or their accountant’s office. These audits are usually very detailed and tend to be performed by the most highly trained auditors at the IRS. Some field audits are performed by specialists in certain industries. During a field audit, the auditor will review financial records, meet with employees and tour the premises. This can include a home office.
Expect the field auditor to examine bank statements and accounting records, at a minimum. The auditor will also be looking for discrepancies between the taxpayer’s lifestyle and the income reported on the tax return.
Office audits (or “desk audits”): Office audits take place at the IRS office near the taxpayer’s location. We typically see office audits in cases of issues with itemized deductions, business expenses and business income. The auditor will request specific information to be brought to the office. Office audits typically require one meeting, unless follow up meetings are required.
Correspondence audits: Correspondence audits are done solely through the mail and are the most common type of audit. Over 70% of audits are correspondence audits. The process begins with a letter announcing the audit, typically containing an initial list of requested information. Unusually the letter provides a 30-day period to respond.
Automated Under Reporting Audits (AUR)
Automated Under Reporting audits are a type of correspondence audit that are handled primarily by computers. They are becoming more and more common.
The AUR audit begins with IRS Notice CP2000 which the the IRS uses when information from a third party source (such as a 1099 or W-2) does not match the information the taxpayer reported on their tax return. Notice CP2000 is also called a Notice of Underreported Income. The taxpayer should respond promptly to the Notice CP2000. Usually, the taxpayer has 30-days from the date printed on the notice to respond.
The IRS will send a follow-up notice to taxpayers who do not respond to Notice CP2000, or if the IRS does not accept the additional information provided. This second notice is called a Statutory Notice of Deficiency. The Statutory Notice of Deficiency provides detailed information about why the IRS proposes a tax change and how the IRS determined the change. The notice tells the taxpayers about their right to challenge the decision in Tax Court if they choose to do so. It is critical to respond to this notice within the required time period, in order to preserve legal rights.
Preparing for the IRS Audit: Audit Basics
We believe that it is important to establish a friendly, non-hostile environment when working with IRS auditors. The staff at the IRS are people too and we find that having a cooperative relationship with the auditor helps to resolve the audit efficiently, with less expense and generally with a better outcome.
We also believe that IRS audits should be handled by professionals, such as experienced CPAs, tax attorneys or Enrolled Agents. While hiring a professional is expensive, the risk of a “do it yourself” audit typically exceeds the savings in fees. Audits are fraught with emotions and fears and it is easy for an untrained taxpayer to take the audit in a bad direction.
At our CPA firm, we generally represent the taxpayer at the audit interview. The taxpayer does not attend. This requires the CPA to be very knowledgeable about the client’s situation in order to be able to answer all the questions of the auditor. Careful preparation is required.
Our philosophy of audit preparation is to be prepared for everything. That means that we tie out or validate every number on the return, not just the numbers that the auditor asks about in their initial request. We also review the IRS wage and income transcripts, to see if there is any income left off the tax returns that the auditor might know about. This way, there are no surprises and we are prepared for whatever comes up during the audit.
We find that this approach works well with most auditors and allows us to bring the audit to a favorable conclusion with the least amount of pain and expense.
Responding to the IRS Audit Letter
Information is requested by the auditors in their IRS audit letter, followed by one or more Information Document Requests (IDR). Your CPA or other representative is required to submit records and information to the IRS if requested by an auditor. This includes all documentation or backup that supports the numbers on the tax return. A carefully worded response letter should accompany the documentation.
However, planning and strategy memos are “privileged information” and are not required to be provided to the IRS along with other documents for the audit.
Documentation relating to an audit must never be destroyed. This is considered interfering with the ability of the IRS to do its job and is subject to significant penalties.
Never make a false statement or provide a false document to an IRS auditor. This is serious offense and will trigger significant penalties.
How Long Can the IRS Wait Before Announcing an Audit of Your Tax Return?
Generally, the IRS has three years from the filing date of a tax return to start an audit. Therefore, at an absolute minimum, receipts and other documentation should be retained by the taxpayer for at least three years.
However, if the IRS suspects fraud, or if a return was never filed, they can go back further than three years. For this reason, we generally recommend keeping receipts and other documentations for at least seven years.
Receipts and Other Documentation
Taxpayers are required by law to maintain books and records. This includes receipts and, in the case of a business, bookkeeping and accounting records. This is one of the reasons that a business should maintain some kind of accounting software, such as QuickBooks Online, or hire a bookkeeper.
Bank statements and credit card statements are typically the first documents that the IRS will request. They do not provide definitive proof of the nature of a deposit or an expenditure, but they are a good place to start.
The burden of proof is on the taxpayer to show that they are entitled to a deduction. Receipts are the best proof of an expense. Even if expenses were paid for in cash, the IRS will still require receipts to substantiate deductions.
If W-2’s or 1099’s are not available, your CPA can obtain Wage and Income Transcripts from the IRS, which will provide missing earnings and tax withholding information. However, these transcripts do not show state tax withholding.
If records are not available, then the taxpayer will need to reconstruct expenses using a reasonable method. We like to use the Form 433 method that the IRS uses to reconstruct expenses for collection purposes. This way, pushback from the IRS is unlikely.
The “Cohan Rule” allows taxpayers a deduction where expenses are estimated based on a reasonable method. The taxpayer should disclose to the auditor that they reconstructed expenses and how it was done. The Cohan Rule does not apply to specific situations where estimates are not allowed, such as travel, entertainment and business gifts.
How Long Does an IRS Audit Take?
Most IRS audits are resolved in about five or six months. Some take longer. If the taxpayer’s files are very well organized, it is possible to resolve the audit in less time.
The audit will take more time if the taxpayer and their CPA wishes to appeal the decision of the audit. That can take up to a year or even longer.
Hobby Losses Often Result in IRS Audits
Losses from a hobby are not deductible against other income. A hobby loss audit is when the IRS believes that an an activity which is continually losing money is really a hobby and not a business. The intent of the taxpayer is important in a hobby loss audit.
The IRS looks at 9 factors to determine if an activity is really a business or a hobby. Expect that the IRS will focus on these 9 factors during a hobby loss audit. These factors are:
- Is the activity conducted in a business-like manner?
- The expertise of the taxpayers and/or his advisors
- The time and effort expended by the taxpayer in carrying on the activity
- Expectation that the assets used in the activity will increase in value
- Success of the taxpayer in carrying on similar or dissimilar activities
- Taxpayer’s history of income or losses with the activity
- Amount of occasional profits, if any from the activity
- Financial status of the taxpayer
- Elements of personal pleasure or recreation from the activity
Cash-Based Businesses are a Common Target of an IRS Audit
Cash-based businesses are a hot-button issue for auditors at the IRS.
During an audit of a cash-based business, the IRS will look at sales tax returns, bank deposits, point of sale (POS) records, and 1099s received to make sure that all cash income was reported on the tax return. On the expense side, the auditor will look for evidence of payment (usually receipts) to justify deductions on a return. They will also check to make sure that the expenses are ordinary and necessary for this type of business and in line with industry statistics.
In addition, IRS auditors of cash-based businesses look for indicators of unreported income, such as:
- Excessive lifestyle
- The business continues to operate despite losses every year
- Bank deposits continue to increase despite losses or low income
- No income is reported yet debt decreases year after year
- Unusual margins or sales for this type of business
30-Day Letter
Toward the end of the audit, the auditor will list the proposed adjustments to the tax return on Form 4549, also called a 30-Day Letter. The taxpayer may either agree or disagree with these adjustments.
If the taxpayer agrees with the proposed adjustment to the tax return, then the additional tax must be paid, plus penalties and interest. The taxpayer has the option to enter into a payment arrangement for the amount due, such as an installment agreement or offer-in-compromise.
IRS Appeals
If the taxpayer disagrees with the adjustments in the 30-Day Letter, then we have 30 days to bring the case to to IRS Appeals.
While Appeals may sound scary, it is not. The staff at IRS Appeals is usually very reasonable and they are eager to resolve the matter efficiently and fairly. Appeals is an opportunity to settle the audit without the need for litigation.
We experience great results at IRS Appeals, including the removal of penalties.
Notice of Deficiency (90-Day Letter) and US Tax Court
If the taxpayer does not respond to a 30-Day Letter, then the IRS will issue a Notice of Deficiency. This gives the taxpayer 90 days to file in US Tax Court.
A Notice of Deficiency may also be issued if the taxpayer has less than one year remaining on the audit statute of limitations and does not agree to extend the statute of limitations.
US Tax Court
Filing in US Tax Court does not necessarily require litigation because the case will first be forwarded to IRS Appeals.
As stated above, IRS Appeals is an excellent venue to settle the audit in a reasonable and less-costly manner. If the case is not settled at IRS Appeals, then the case goes back to US Tax Court to be litigated.
And litigation in US Tax Court is an expensive ordeal.
IRS Collections
If the taxpayer does not file in tax court and the 90-day period expires, the IRS will use of all its powers to collect the additional tax, penalties and interest resulting from the audit. This will likely result in liens, levies and garnishments.
Once the tax debt is in IRS Collections, there are a number of available procedures that the taxpayer can follow to resolve the debt due to the IRS. These include the offer in compromise, installment agreement or payment plan, or currently non-collectible status. Each procedure comes with its advantages and disadvantages.
Who Does the IRS Audit? Updated for 2024
On February 29, 2024, the IRS announced a new audit effort focused on high-income taxpayers who have failed to file federal income tax returns. The new initiative begins with IRS compliance letters going out on more than 125,000 cases where tax returns have not been filed since 2017. The mailings include more than 25,000 to those with more than $1 million in income, and over 100,000 to people with incomes between $400,000 and $1 million between tax years 2017 and 2021.
These are all cases where IRS has received third-party third party information—such as through Forms W-2 and 1099s—indicating these people received income in these ranges but failed to file a tax return.
People receiving these letters should take immediate action to avoid additional follow-up notices, higher penalties as well as increasingly stronger enforcement measures. People in this category should also consult with a CPA so they can quickly file their late tax returns and pay delinquent tax, interest and penalties. The failure-to-file penalty amounts to 5% of the amount owed every month – up to 25% of the tax bill.
People who don’t respond to the non-filer letter will receive additional notices and other enforcement actions. Ultimately, this can lead to a variety of IRS compliance activity, including collection and audit action as well as potential criminal prosecution. As part of this, the IRS can also take steps to file what’s known as a Substitute for Return (SFR).
If a person repeatedly fails to respond and does not file, the IRS may create a substitute tax return for the taxpayer. The IRS calculates this substitute tax return based on wages and other income reported to the agency by employers, financial institutions and others. The return factors in the tax, penalty and interest owed by the taxpayer.
Substitute for Return in 2024
A “substitute for return” is a tax return prepared by the IRS on behalf of the taxpayer. This return might not give the person credit for deductions and exemptions they may be entitled to receive because the IRS does not know each taxpayer’s situation. In this scenario, the IRS will send a notice of deficiency CP3219N (a 90-day letter) proposing a tax assessment. The taxpayer will have 90 days to file the past due tax return or file a petition in Tax Court. If the person does neither, the IRS will proceed with the proposed assessment.
If the IRS files a substitute return, it is still in the person’s best interest to file their own tax return to take advantage of any exemptions, credits and deductions they are entitled to receive. The IRS will generally adjust the account to reflect the correct figures.
The tax return the IRS prepares for these taxpayers will likely lead to a tax bill, which, if unpaid, will trigger the collection process. This can include such actions as a levy on wages or a bank account or the filing of a notice of federal tax lien. If a taxpayer repeatedly does not file, they could be subject to additional enforcement measures, such as additional penalties and/or criminal prosecution.
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Call us at 678-235-5460 (Atlanta) or 773-828-0551 (Chicago) to discuss your IRS audit in detail. Or email us at gary.massey@masseyandcompanycpa.com. Our friendly CPAs, Enrolled Agents and tax advisers are here to help you through every step of your IRS audit.
Massey and Company CPA is a boutique tax and accounting firm serving individuals and small businesses in Atlanta, Chicago and throughout the country. Our services include tax return preparation, tax planning for businesses and individuals, IRS tax problem resolution, IRS audits, sales tax, and small business accounting and bookkeeping.
