What Is a Tax Audit? - SmartAsset

America uses what is known as a self-reporting tax system. This means that at the end of each year, you calculate your income, assets and liabilities, then tell the government what you owe. The IRS then double-checks your work against its own records. The agency has several options if it disagrees with your filing. Most of the time, the IRS simply sends you a miscalculation notice. This is a letter saying that the IRS believes you did not pay the correct amount, but that it also believes the error was due to a mistake or otherwise made in good faith. If the IRS believes that your taxes deserve a closer look, it can conduct what is known as an audit. Here’s what it means when the IRS conducts a tax audit.

You can work with a financial advisor to put you in the best position of preventing a future audit.

What Is an IRS Tax Audit?

An audit is essentially when the IRS double-checks your taxes. It compares your paperwork against records such as receipts, bank statements, pay stubs and any other relevant documents in order to confirm the information that you gave them.

The IRS does not typically conduct an audit if it simply disagrees with your calculations. When the agency feels that the information on your 1040 is accurate and complete, but simply misapplied, they will recalculate your taxes and send a miscalculation notice. An audit typically takes place if the IRS has reason to believe that your taxes contain information that is inaccurate.

What Triggers an Audit?

This may be one of the most common questions in all of the accounting. How does the IRS choose which files it audits? There are several answers to this. First, the IRS has three ways by which its computers will flag a file for audit:

Random Selection

The IRS selects a certain number of tax returns to randomly audit each year just to make sure their records are operating correctly and to keep many honest with a looming audit.

Computer Screening or Irregularities

The IRS automatically screens tax returns for irregularities or other anomalies. As the agency’s website describes the process, it “[compares] your tax return against ‘norms’ for similar returns.” The agency may pull your file for further review if something about your tax return seems out of the ordinary.

Related Examination

Finally, the IRS will sometimes audit a tax return when they have some relationship with other taxpayers that were audited. This is particularly the case when someone has a financial relationship with a business or investor that was audited.

Once the computer identifies a file for audit based on random selection, irregularity or relationships, then an auditor reviews the file. This auditor decides whether to move forward with an audit. Many potential audits don’t move past this human review stage. Reviewers will weed out many, if not most, simple income tax returns because they don’t have issues that would raise a red flag. Reviewers also tend to eliminate high-income or high-complexity returns, because these tend to belong to taxpayers who can mount expensive legal defenses that will drain the IRS’ limited enforcement resources.

For most taxpayers, irregularities are the biggest concern. One of the most frequent questions when it comes to tax audits is what kind of issues will likely trigger a review by the IRS. The truth is that there is no one, set answer to that question. The IRS uses a constantly changing series of criteria, updating its database every year. That said, it is common for the IRS to red flag a file if it suspects issues such as:

Underreported income
Excessive charitable donations
Excessive business losses or expenses
Underreported investments
Round or estimated numbers

How Does an Audit Work?

If the IRS does decide to audit you, the process can potentially involve a review of your entire tax return. They will check each claim you have made in your taxes against third-party records. For example, if you claim a business expense they will want to see the receipts or bank records for that spending. If you have claimed income, they will want to see your pay stubs to confirm that you reported all of the money that you earned. The agency lists some of the records it often requests on its website.

For this reason, most taxpayers actually have nothing to fear from an IRS audit. The average taxpayer makes their money through W-2 employment, which the IRS receives copies of, and takes the standard deduction rather than itemizing their claims. As a result, there’s very little that the IRS could investigate in a standard 1040.

If the IRS does conduct an audit, it does so in one of three ways:

Mail Audit

The IRS will send you a letter asking for additional documentation regarding certain parts of your income taxes. For example, they may request additional proof of income or receipts for specific expenses. In this case, you can mail back the documents as appropriate and, if they answer the agency’s questions, that will typically be the end of the matter.

Office Audit

The IRS will request you to come to a local office to answer questions about your tax returns in person and to provide records that address any concerns it has with your taxes. You will be responsible for preparing any information that they request either before the appointment or during their questioning. There may be follow-up appointments to give you time to present the information they request.

Field Audit

Finally, the IRS might conduct the audit at your home, business or accountant’s office. As with an office audit, in this case, they will want to ask you questions about your tax returns and will request specific documents that address any irregularities. A field audit can also involve the seizure of documents and assets if the IRS decides that the case may involve elements of fraud.

As a taxpayer, you are required to keep all documents related to your taxes for three years, meaning that the IRS can ask you for pay stubs and receipts within the last three years and expect an answer. This is the standard statute of limitations for a tax audit.

However, the law does allow the IRS to audit taxes up to six years old if it believes that they involved a “substantial understatement of income,” generally meaning that you left out 25% or more of your earnings. If the IRS argues that your taxes involved an element of intentional fraud, rather than error, it has no statute of limitations on how far back it can audit a file.

The process of an audit depends entirely on the complexity of your taxes. Ideally, this is an easy process. For example, a taxpayer who kept receipts for every deduction and expense that they claimed might dispose of an audit in as little as an afternoon by simply showing up with the requested documents. If you have complicated taxes or lack documents for everything on your taxes, the process can take months or even years.

What Are the Consequences of an Audit?

Many people worry about the outcome of an audit and what it will mean to them when they first get notified. There are four outcomes to an audit, with the first two on our list being the two most common outcomes.

No Change: This is the most common outcome of an audit. In this case, the IRS decides that you have answered their questions and it accepts your taxes as filed.
Agreed Changes: The IRS decides that some elements of your taxes were incorrect. They adjust your taxes and present you with a bill, plus additional interest and penalties based on the specific circumstances. If you choose not to dispute these changes you can either pay the bill or set up a payment plan.
Disputed Changes: The IRS decides that some elements of your taxes were incorrect. As above, they adjust your taxes and present you with a bill that includes interest and penalties as appropriate. If you disagree with this finding, you have several options including a second review by the IRS, internal mediation or even resolving the matter in court.
Criminal Referral: This is a rare outcome of an audit. If the IRS determines that your taxes involved elements of fraud or other willful misrepresentation, it may refer your case to law enforcement for prosecution. This is rare, but not unheard of. Criminal referral applies in addition to paying any taxes and penalties.

The Bottom Line

A tax audit occurs when the IRS questions and reviews some element of your income taxes, from your claimed earnings to your expenses and deductions. They are typically routine procedures that involve little more than showing your receipts, but they can quickly turn into an issue for law enforcement if fraud is involved.

Tips for Tax Planning

The best thing is not having to worry about your taxes. The second best thing is having someone else do the worrying for you. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
It’s not uncommon to hear from the IRS, especially if you’re a freelancer or self-employed. But what exactly does it mean when they say your return has been flagged for review?