Tax Audit

A tax audit is an examination of a person's tax returns performed by a federal or state tax agency to determine whether the income and deductions reported by the taxpayer are accurate. The purpose of conducting an audit is to minimize the tax gap.

When selected for audit, the Internal Revenue Service or IRS notifies the taxpayer via mail. Typically, the IRS asks taxpayers to submit additional documentation to support their reported earnings and deductions. Usually, the IRS selects taxpayers based on suspicious activities. However, sometimes audits are random. There are three types of tax audits — mail audit, office audit, and field audit.

• Tax audit means examining an individual's or organization's tax returns to ensure that the taxpayer accurately reported the income and deductions in their tax returns.
• The different tax audits include - Field and mail audits are two examples.
• This audit offers various benefits. For example, it helps the IRS minimize the tax gap.
• There are various reasons for tax audits. For example, a taxpayer did not include all their earnings, or a person claimed tax credits without providing proper documents.

The tax audit meaning refers to a formal investigation conducted by the federal tax agency or state tax authority to confirm whether a taxpayer paid taxes correctly. For example, the IRS checks the information reported in tax returns to determine whether a taxpayer has adhered to the tax laws.

If the IRS selects a person for audit, they notify the person via mail. The letter sent by the federal tax agency will inform the taxpayer whether the review will take place in person or via mail. Moreover, it will have instructions for taxpayers on how to proceed. An audit request includes the details one must provide to verify the items in a tax return, for example, income, expenses, and itemized deductions.

Typically, audits conducted by the IRS include the last three years' tax returns. If the tax authority spots a significant error, it may add extra years. The IRS does not go back more than the last six years.

When the IRS asks for too many records, the taxpayer may request an in-person or face-to-face audit. Besides providing the required information, taxpayers may have to prepare answers regarding their financial activities.

Individuals and organizations can request an extension if they are not ready for the audit. However, individuals must note that if they outright ignore the audit letter, they may end up paying for it in interest, taxes, and penalties. That said, taxpayers have 90 days to petition if the federal tax agency changes their tax return or proposes penalties and taxes. If a taxpayer continues to ignore the audit letter, the IRS may start the collection process by seizing their assets, such as funds in a bank account, wages, vehicles, and real estate.

Let us look at some reasons for tax audits.

• The taxpayer did not include their full income: Every year, the IRS gets copies of a taxpayer's 1099 and W-2 forms. Then, the federal tax agency automatically compares them with their tax return. If the system identifies a mismatch and spots that the taxpayer forgot to report some income, the IRS may choose to conduct an audit.
• The taxpayer claimed tax credits: If a taxpayer claimed deductions, tax credits, or tax breaks and did not provide proper documentation, they may be subject to an audit.
• The taxpayer made a math error: Using a professional's help or tax prep software can reduce math errors. That said, the chance of miscalculation or entering figures incorrectly remains. In the case of a small error, the IRS may first notify the taxpayer regarding the mistake and offer a way to fix it instead of conducting a full-fledged audit.
• The taxpayer failed to report foreign accounts: If a taxpayer has assets worth over $50,000 in a foreign bank account, they must report it per the IRS's requirements.
• The taxpayer included questionable losses and tax deductions: When someone owns a company, the tax returns can become complicated. For example, If a business's loss or profit on Form 1040 or Schedule C seems unlikely compared to the industry claim, the IRS could view it as a red flag. Also, the IRS is likely to audit if they spot unreported earnings or unusual business losses or deductions for a few consecutive years.
• The taxpayer did not report their cryptocurrency: The IRS pays a lot of attention to digital assets because of the increasing popularity of cryptocurrency. Therefore, even if taxpayers do not receive tax forms, they must report digital assets and pay taxes.

The following are the different types of tax audits

#1 - Field Audits

Field audits are face-to-face audits conducted at the local IRS office. Compared to a mail audit, this is more thorough, and typically taxpayers have to answer the auditor's questions regarding their financial activities and income tax returns. In addition, the auditor may ask the taxpayer to bring certain information to the office, for example, their bank statements and receipts.

 One must note that individuals can bring their lawyers to the office to represent them.

#2 - Mail Audits

A mail audit does not require a taxpayer to meet the auditor in person. Instead, Individuals can send the additional documentation required by the IRS in response to the audit letter sent via mail. Usually, submitting adequate proof will conclude the investigation in the taxpayer's favor.

#3 - Office Audits

In the case of a tax audit, an IRS agent carries out an audit at the taxpayer's place of business or home. Usually, the IRS conducts field audits when they have questions regarding more than one or two deductions. Such an audit is typically very thorough and may even cover all the items in a tax return.

Let us look at a few tax audit examples to understand the concept better.

Example #1

On December 22, the House passed a bill requiring yearly tax audits of the president's income tax returns, codifying an Internal Revenue Service policy. This happened after a congressional committee disclosed that the federal tax agency did not formally review the former U.S. government's tax returns.

The IRS policy mandates the audit of sitting presidents every year. Since 1977, this has been the case. However, the terms are defined in IRS's regulatory manual, not the federal law. This bill passed by the House will codify the outlined terms into law.

Example #2

Suppose David claimed $8,000 in charitable donations. The IRS sent him an audit letter asking for proof of the donations. He submitted the proof according to requirements, thus resulting in the conclusion of the mail audit in his favor.

The following are the benefits of tax audit:

• A tax audit verifies that the deductions and income reported in the tax returns are genuine.
• It eliminates the chances of deception and minimizes the tax gap.
• A tax audit ensures that a business adheres to tax laws.
• It can improve a business's credibility.

Individuals new to finance often confuse a tax audit with a statutory audit. However, one must understand their distinct features to know how they differ. So, the table below highlights the critical differences between them.

This has been a guide to what is Tax Audit. We explain its comparison with statutory audit, its types, reasons, examples, and benefits. You can learn more about finance from the following articles –

• Audit Committee
• Taxation
• Tax Evasion