An audit is without a doubt the most dreaded outcome of the tax filing process, and the situation carries with it some unsettling mystery.
The standard nightmare has IRS agents with badges and briefcases showing up on your doorstep. Another vision shows you being thrown in the poorhouse because of unpaid taxes or thrown in jail because the IRS thinks you lied.
Receiving a notice of audit from the Internal Revenue Service definitely has a tendency to set people’s nerves on edge. But audits contrast greatly from their thriving myths.
Really, less than 1% of filers get audited. That’s a very small percentage.
Let’s understand what an audit really is…an audit is the way the IRS minimizes the “gap” or difference between what the IRS is owed and what they actually receive in tax payments.
There are actually 3 different types of audits.
#1. Mail Audits:
Mail audits are fairly routine. They require you to mail in documents pertaining to specific questions or requests for information.
Mail audits make up about 77% of all audits.
#2. Office and Field Audits:
Office and field audits are a bit more serious. The IRS will ask for information to validate your deductions and credits. They will also look closely at your lifestyle, business activity and income to see whether your tax return is accurate.
#3. CP2000 Notice:
(Under-reporter Inquiry)
The IRS automatically sends these notices when there’s a discrepancy between income you reported on your return and information that your employer or other payer provided to the IRS through statements, such as Form W-2 and Form 1099. A common example is when taxpayers don’t report Form 1099-MISC income from work they did as an independent contractor during the year.
The audit process is a little different based on what type of tax returns are filed. For example, an individual tax filer would require a more simple audit than a business filer. Additionally, a business audit would differ greatly from a law office audit.
Let’s take a look at a few things an auditor might do to prepare for a law office audit. They might use a database called Accurint. This provides information on a person, their business, their professional standing, their assets, pending or resolved litigation, and other matters.
Another source of information they could use is the Martindale Hubbel Directory. This is a national directory of attorneys. It provides information on an attorney’s educational background, the year they were admitted to practice, areas of expertise, and a “peer review” rating.
A thorough understanding of the law practice’s bookkeeping system is also necessary. Accounting systems vary widely depending on the types of transactions conducted and the types of law practiced.
Records for trust account(s) should also be requested. Most attorneys will have one or more trust accounts under their control. The auditor will question the attorney about the use of each account. Careful reconciliation of the trust account(s) to the attorney’s other bank accounts are necessary to determine if there is additional unreported income.
After a case has been settled,and the settlement is received, the attorney’s fee is available and therefore should be included in income. An effective audit step is to analyze the source of funds remaining in the trust account at year-end, particularly if there is a large ending balance.
As you can see by this example, the depth of the audit process can differ greatly depending on the filer.
So How does the IRS determine who gets audited and who doesn’t?
The IRS uses a system called the Discriminant Information Function to determine what returns are worth an audit.
- The DIF is a scoring system that compares returns of peer groups, based on similar factors such as job and income.
- If a person’s financial data differs significantly from those established by his peers, the system gives that return a high DIF score.
- A high DIF score raises the chances that the filer will be audited.
Although the IRS audits only a small percentage of filed returns, there is a chance that one day they might choose you.
Here are some of the most common reasons for an IRS Audit:
- Data Entry Errors
- Unreported Income
- Overstating Deductions or Disproportionately High Deductions
- Claiming Non Existent Dependents
- Wrong Filing Status
- Claiming Non Existent Dependents
- Claiming Earned Income Credit
- Self Employment
Whether you are a single person, married with a family, filing for your small business or having taxes prepared for your law practice, when you file your taxes, you’re basically telling a story. You’re putting forth your story and if you’re questioned, the IRS is stating that they read your story and they want you to show them where you got your information.
Triggers for an audit aren’t inevitable and automatic. Only when the financial picture painted in the tax return stands out as atypical or beyond common sense should someone be concerned about an audit.
They’re not going to just come take all your money. If you owe the money, they will eventually get it. But as long as you talk to them, you don’t have to fear that something is going to happen to you without your control. You can also assert your right to appeal if necessary. Know that the auditor’s decision is not final.
We can all agree that tax audits are no fun. Even if you are confident everything is correct on your return, you may not be able to avoid an audit. But if you’re careful in completing your return each year, your chances of an audit will shrink. You can also hire a bookkeeper and/or CPA to take care of your books and tax records. This can greatly reduce your audit risk and offer some support in the event an audit does occur.
