Understanding an IRS Audit
Similar to the blue lights flashing behind you on the highway, the letter from the IRS announcing a tax audit sets most people’s heart racing. Let’s look at why you may have been selected for audit, and what the IRS might be looking for.
When you file your return, the IRS assigns it a DIF (discriminant index function) score. Returns that receive a higher score are more likely to be chosen for audit. Unfortunately, the IRS doesn’t disclose the formula used to arrive at the score but it is thought to be based on averages of similar returns.
You might come under scrutiny if you have done business with another company who has been audited. For example, if you are paid as a subcontractor and that company is audited and found not to have issued 1099s, this could open you up to IRS audit. The IRS also has a whistleblower informant program where they issue awards to people who blow the whistle on persons who fail to pay the tax they owe.
The IRS also matches reported income to the various 1099 and W-2 forms issued to that payee. When the matching system finds discrepancies, you are most often notified via an IRS CP2000 notice. While this notice is not a true IRS audit, it can still be alarming and most definitely needs to be addressed.
Very often the IRS will have started their investigation before you are even notified of the audit. They may be looking at your lifestyle (the cars you drive, the house you live in, and boats and other “toys” you have) to see if this is reasonable based on the income you report. They might look at charitable contributions to see if amounts claimed are within the range of what is normally reported by people of your income level. If you are involved in a business that is primarily conducted in cash, they may question whether all income is reported. During an audit, they often reconcile deposits into your bank accounts with income reported on your return. Of particular interest will be hobbies that are veiled as business activities resulting in losses on your return. They also often examine home office deductions, request logs for automobile expenses, and documentation for the business purpose of other travel and meals expenses deducted on your return.
If you do receive a notice from the IRS, contact us immediately and provide a copy of the notice. We always recommend that you do not attempt to navigate an IRS audit on your own. We are here to help.
Sandra Y Caterine, CPA, MST, is a Tax Principal at Katz, Nannis + Solomon, P.C. If you have any questions or would like to speak with one of our tax professionals, please contact our office at 781-453-8700.