IRS Audit Preparation Tips

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In 2010, 1,581,393 IRS audits were performed by the U.S. Internal Revenue Service according to Syracuse University federal tracking data. Of these audits 78.3 percent were by correspondence and 21.7 percent involved in person contact with an IRS agent. Depending on whether or not the audit takes place via correspondence or in person influences how a taxpayer prepares for the IRS audit. In either case, there are several pro active ways to prepare for an IRS audit that can potentially save time, money and reduce tax related stress.

Awareness of audit probability

Being aware of what triggers an audit, and the chance of an audit occurring are a good way to ready oneself for an audit. For example, in a March, 2011 article in Forbes magazine, Tax Lawyer Robert W. Wood states of total 2010 IRS audits 30 percent claimed the Earned Income Credit meaning at least 30 percent of audits occur for the lower end of the income scale. Knowing this, taxpayers might choose to exercise more caution when claiming this particular tax credit. Furthermore, reviewing IRS publications such as the Fiscal Year 2012 Annual Audit Plan provides insight into the direction and focus of IRS audits.

Familiarize with audit process

Knowing how IRS audits work can help expedite the process and avoid unforeseen consequences. Lesson four of The IRS audit video series guide is helpful in audit preparation and provides information about what is required of taxpayers during an audit. For example, during an audit, a taxpayer may receive either an IRS Form 4564 or Form 886-A detailing what specific documents the IRS requires from the tax payer. Additional videos in this series provide a comprehensive overview of the audit process as well as audit tips. IRS Publication 556 provides further information about taxpayer privileges such as mediation during an audit dispute.

Understand the IRS Audit Information Management System

The IRS keeps track of its audit activities via what is identified as the Audit Information Management System (AIMS). This system records the total number of audits, and IRS agent hours spent on audits in addition to audit results according to Syracuse University's Transactional Records Access Clearinghouse (TRAC). Understanding how the AIMS  system works and the audit process can be helpful in gaining insight about how to best handle an audit.

Review IRS audit statistics

The IRS publishes its audit information and this can be directly reviewed by taxpayers to get a sense of what the IRS examines in an audit and how they do it. To illustrate, the 2010 IRS Data Book claims that of the total 1,735,083 individual tax filing 'examinations' that took place in 2010, 92 percent of international tax filings required changes. This indicates international tax filers have a high probability of having their tax filing changed by the IRS if they are audited pointing to a higher level of scrutiny, error or both with these types of audit.

Know taxpayer audit rights

If the IRS selects a specific tax filer for audit, it is important to be aware of the rights granted before proceeding with the audit. For example, according to IRS audit information, taxpayers may record an audit interview or relocate the location of an audit upon prior notice and are also afforded the right to representation. Taxpayers may also appeal audits if they disagree with the changes requested by the IRS.

Red Flags On Your Business Tax Return That May Trigger an IRS Audit

The U.S. Internal Revenue Service has decades of experience dealing with tax returns and in that time has developed statistical, formulaic and numerical data on higher risk tax filings in terms of potential tax evasion. The IRS has developed an audit alert warning system that is triggered by certain risk factors that correlate with information submitted and/or not submitted on tax filings. These triggers may be applied to business tax filings. Some of the "red flags" that may cause an IRS audit are as illustrated in the following sections.

Business tax filing red flags

Unreported Business and/or staff Income:

Businesses such as restaurants and sole proprietorships may erroneously or fraudulently under-report certain forms of income leading to a lower reported taxation to the IRS. Certain types of businesses such as those mentioned above are more likely than others to report incorrect amounts and are thus at greater chance of being audited.

Over reported Expenses:

Another potential trigger for a business audit is over reporting business expenses such as automobile expenses, meal expenses, or inventory space used. Typical businesses of certain sizes generally have a 'normal' range of expenses that can be expected, however tax filings that fall outside of this range or are quantitatively unrealistic may set off an Internal Revenue Service warning algorithm.

Inconsistency with Historical Tax Filings:

Businesses may follow various trends such as accounting methods, income growth, expense deductions, employee withholding, depreciation etc. When these trends become unrealistic the probability increases the tax filing is erroneous. For example, if a business reports depreciation of 2% every year for 5 years in a row and then reports depreciation of 7% this indicates a change in accounting methods from straight line depreciation to accelerated depreciation. Changes like this and other adjustments to accounting systems may have to be formally reported and could lead to an audit.

Missing IRS Forms:

Every business, whether it be a sole proprietorship, partnership, limited liability corporation, S-Corporation or C -Corporation has certain filing requirements which include specific forms to be completed and sent to the IRS. For example, partnerships are required to file a form 1065 or U.S. Return of Partnership Income. If these forms are missing or incomplete there is a significant chance the IRS may inquire further, request more information or audit the business.

Sole proprietorship and other red flags

Taxable Income Range:

The greatest amount of tax filing audits occur for tax forms reporting taxable income in excess of $100,000.00. By reducing one's taxable income to under this level one is statistically reducing one's chance of being audited by approximately 45.23%. If one reports income below $50,000.00, the tax filer is reducing statistical probability of audit by around 16.89%

Incorrect 1099 or other Previously Reported Information:

Employers and financial institutions all report data to the Internal Revenue Service independently. This means the IRS has a means of comparing one set of information with another. For example, form 1099's which are other income earned forms are reported to the IRS separately by financial institutions. Misstating the same information the IRS already knows about can trigger an audit. Other information that may be previously reported to the IRS includes interest on loans, mortgage payments, and property tax. Erroneously reporting these figures is also liable to activate a red flag with the IRS.

Income Tax Deductions:

Another area that is subject to triggering a potential audit is the quantitative amount of deductions made on a tax filing. If the deductions are disproportionately large or numerically inconsistent with the tax filers other financial data, the audit alert may trigger causing an audit inspection. For example, a sole proprietor may over report home office space used for inventory storage. If that proprietor has a home that is 1300 square feet and the expenses reported are for a space of 980 square feet, this may exceed the logical space for a home that can be utilized for storage as most homes require a certain amount of square footage for living space.

U.S. Internal Revenue Service audits are prompted by computer algorithms based on historical financial and tax reporting statistics. Essentially, dishonest tax reporting is recordable in the form of tax filing patterns and/or trends. Some of these patterns and trends are correlated with the red flags illustrated above and may cause an IRS tax audit. Additionally, some tax filing classes such as those within a certain type of business or taxable income range are statistically more likely to be audited than others. This is because these businesses or tax filers are either likely to generate more tax revenue for the IRS and/or have a historical likelihood of erroneously reporting tax data than other tax filing categories.

Sources:

1. http://biztaxlaw.about.com/od/businessaudits/a/audit_red_flags.htm
2. http://sbinformation.about.com/od/taxes/a/avoidsbaudit_ga.htm
3. http://www.irs.gov
4. http://www.wwwebtax.com/audits/audit_avoiding.htm