The IRS audit rate is quite low. But lucky you, you have received an IRS audit notice. Fun stuff.
So what do you do? Or what can you do to prepare?
There are several things that you might start with.
Before getting into those, let’s stop to think about how the IRS audit process.
The IRS Audit Process
The IRS audit process typically starts with a letter from the IRS indicating that a tax return has been selected for audit. The IRS opening letter will typically
- Identify the tax form, tax year, and taxpayer (if it is not an individual income tax return) that is being audited.
- Provide the contact information for the IRS agent assigned to your audit.
- Ask the recipient to contact the IRS agent to schedule the opening meeting.
The IRS opening letter may even include a list of items that the IRS agent would like to review at the opening meeting.
If you have received this type of letter, here are a few of the things that you need to do to prepare for the upcoming audit.
Preparing for the Audit
A few simple steps at the outset of the audit can make the process much smoother. Here are a few suggestions:
1. Gather records that identify what items of income you received.
This may include your tax returns, tax forms (such as Forms W-2, Forms 1099, Schedules K-1, etc.), and bank or other deposit account statements. Compare the total income to the amounts reported on your tax return. Note any discrepancies and be ready to explain them.
Get a copy of your IRS wage and income transcript. Compare the income reported on the transcripts to the amounts reported on your tax returns. Note any discrepancies and be ready to explain them.
Identify any large or unusual items of income. Be ready to explain these items if the IRS agent inquires about them.
You should also understand how the IRS makes adjustments to income. The IRS will likely be checking this during your audit.
2. Gather records that identify your largest or first time expenses.
You might start this process by reviewing your tax return and the expenses that were actually deducted on the return (or those that factored into a tax credit).
You should locate records for the large or unusual expense deductions. This may include requesting bank, mortgage, brokerage, loan, and other statements–preferably statements for the entire year and/or cashed checks for unusual or unusually large expenses. You should also be ready to explain these items if the IRS agent inquires about them.
The IRS auditor may question all expenses or just pick a few of the larger or more questionable items. There are some deductions the IRS will almost always question, such as meal and entertainment expenses.
3. Focus on smaller items that have a number of entries or transactions, even if they are not individually or collectively the largest numbers on your tax return.
IRS auditors often review this type of items, as it gives them something to verify. These items are auditable.
The downside is that these items may require a significant amount of documentation to support. It may be advisable to get a head start on pulling these records or at least organizing the information so that the records can be located easily. If you didn’t pay for an accountant previously, this is where you will be doubting your decision making abilities. Don’t worry, you aren’t the only one who didn’t use a bookkeeper.
If you didn’t use a bookeeper and your records are a mess, you may have to summarize or sort the records electronically or in folders. This may mean going back to your bank data online.
Pay particular attention to receipts for charitable gifts and business expenses.
If your records are completely missing or completely inadequate, you may want to read up on how to use estimates in an IRS audit instead of actual records. This is acceptable in some cases.
If you really want to be upset, you can read about this case where the taxpayer had to produce records from 20 years ago. If you are feeling really brave, you might read about this case where the taxpayer had to produce records from 40 years ago.
4. Locate rental and other lease agreements and employment agreements, contracts, etc.
You don’t have to pull these items just yet, but know where they are if asked. And note that this includes both personal and business agreements and contracts.
The IRS agent will want to review some of this information to verify the income and expense items on your return. If these items do not come up, they can be used to bolster other positions (or even to pad the IRS file if there are other related issues where the records are not so plentiful).
5. Relax (and consider hiring a tax attorney).
IRS audits happen and taxpayers do survive. If you are prepared (and with a bit of luck), you may end up with no change to your tax return. Even if this is not the case, the IRS audit process can be an educational process whereby you improve your personal finance and/or business knowledge.
If you are still worried, it may be time to hire a tax attorney. Yes, we do this work. If you want to talk to one of our tax attorneys, please give us a call.