Taxes are an inevitable part of life. As a business owner or individual taxpayer, you want to ensure you are paying your fair share and following the rules. Tax audits are one way the IRS and state tax authorities enforce compliance. Being audited can be stressful, but going in informed can help ease the process. That's why it's important to understand the different types of tax audits and what triggers them. This article will provide an overview of the audit process and the 9 most common types of tax audits.
What Is a Tax Audit?
A tax audit is an examination of a tax return, usually by the IRS or state tax authority, to verify the information being reported is correct. Audits can apply to individual income tax returns or business returns. The goal is to check for errors, omissions, and false information. If issues are found, the taxpayer may have to pay additional tax, interest, and penalties.
Audits can take place in different ways; through mail correspondence or in person at a taxpayer's home or place of business. They can also have varying levels of intensity, from reviewing specific information to a full investigation. The type and scope depend on the situation triggering the audit and the potential amount of tax impact.
Tax Audit Triggers
Certain factors can increase the chances of being selected for an audit. Some red flags include:
- Large, unusual deductions or business losses
- Dramatic fluctuations in reported income
- Math errors on returns
- Transactions with offshore accounts or entities
- High expenses to income
One of the emerging red flags today is associated with cryptocurrency transactions. As digital currencies gain popularity, the IRS is paying closer attention to their use and reporting.
To avoid a cryptocurrency audit, it's crucial to report all your transactions accurately and have proper documentation. Misrepresenting or failing to declare your transactions can draw unnecessary attention. With proper documentation, you can avoid excessive scrutiny.
Types of Tax Audit
The following are the common types of tax audits:
- Correspondence Audit
The most common type of audit is a correspondence audit. It is done by mail rather than in person. The IRS will send a letter requesting additional information about items on your tax return. This may include forms, receipts, or other documentation. You have 30 days to respond by mail. Correspondence audits usually focus on substantiating deductions, credits, or other specifics on your return. They tend to be fairly limited in scope.
- Office Audit
An office audit requires you to visit your local IRS office. You will meet face-to-face with an IRS agent who will review your documentation and ask questions about your tax return. Office audits are more in-depth than correspondence audits. They involve examining your entire return and often focus on more complex issues. Make sure to bring thorough records and documentation.
- Field Audit
A field audit is conducted by an IRS agent visiting your home or place of business. The agent will request records, documentation, and explanations about your tax return. Field audits are comprehensive and evaluate your entire financial situation. They focus on complex issues like business expenses, capital gains, and rental properties. Thorough record-keeping is essential to get through a field audit smoothly.
- National Research Program Audit
The IRS runs the National Research Program to measure voluntary compliance and the "tax gap." This program selects returns at random for intensive audits, even if there are no red flags. Due to the comprehensive scope, an NRP audit can take several months to complete. They examine all aspects of your return in detail.
- Mail Audits
A mail audit is related to a correspondence audit but is initiated based on information received from third-party sources. This includes forms like W-2s and 1099s that are filed by your employer, banks, brokerages, or other payers. The IRS compares these third-party documents to your return to look for discrepancies. Mail audits usually focus on a specific issue, like unreported income.
- Partnership Audit
Audits can occur at the partnership level if a business is organized as a partnership. This involves examining the partnership's federal tax filings rather than individual partners' returns. Partnership audits look at the allocation of income, deductions, credits, etc. among partners. Any changes affect the individual partners' returns. Having partnership accounting records in order is critical in this scenario.
- S Corporation Audit
Like partnerships, S corporations can be audited directly by the IRS. This looks at the business's Form 1120S return. Issues like shareholder basis, salaries paid, and distributions are common audit triggers. The results of an S corporation audit pass through to shareholders, emphasizing the importance of organized individual records.
- Payroll Tax Audit
Payroll tax audits focus on compliance with requirements to withhold and remit payroll taxes. This includes income tax withholding, Social Security and Medicare taxes, and Federal Unemployment Tax (FUTA). Payroll tax audits examine whether the correct amounts were deposited and reported on Forms 941, 940, and W-2. Proper payroll accounting is essential to successfully sail through a payroll tax audit.
- Retirement Plan Audit
The IRS Employee Plans division conducts audits of retirement plans like 401(k)s. These audits ensure the plan complies with requirements for eligibility, vesting, contributions, distributions, and more. The trustee handles a retirement plan audit, but it can have consequences for the sponsoring employer. Fines and disqualification are possible outcomes for non-compliant plans.
Your Rights and Responsibilities During an Audit
Taxpayers have important rights during the audit process. This includes the right to professional representation, audio record in-person interviews, and appeal audit findings. You have the right to clear explanations about requests for information and examination procedures.
You also have responsibilities like meeting deadlines, providing complete information, and keeping scheduled appointments. Failure to comply can lead to more invasive audit procedures.
Conclusion
There are many potential types of IRS tax audits, ranging from minor correspondence audits to extensive field audits. While being audited may seem intimidating, responding promptly and maintaining thorough, accurate records can help resolve any issues smoothly. Audits are a normal part of the tax system that ultimately promotes compliance and fairness. Knowing the basics of the different audit types can give you confidence in your unlikely chance of being selected.
