The IRS conducts audits to ensure it is getting the right income from the right people every year. While it simply hasn’t the resources to check everyone – and no one likes paying too much tax – the IRS audits for mistakes and deliberate errors in bookkeeping. While many people would rather have a root canal dental operation than an IRS audit this is a necessity for the government to get the revenue it requires from everyone.
The IRS audits tens of thousands of tax returns every year. Just because you are being audited may not mean you are in the wrong, and you shouldn’t necessarily worry unless you know you have done something wrong!
Let’s look at some of the reasons you may be audited by the IRS and what it entails.
So what exactly is an IRS audit?
The IRS audit system is there to make sure that the Federal government is taking just the income it should. It has two phases – a computer benchmarking system to highlight potential anomalies in a given tax return and then should the tax agent choose either a discussion of your tax return by mail or in person, in a face to face interview.
Let’s face it, tax returns aren’t simple and the more complex your financial situation the less easy it is to complete a tax return accurately. In most cases you won’t face a prosecution (unless you have deliberately been into tax evasion and can be proven to have done so) as in by far the most cases people have made simple errors that resulted in a lower than necessary payment to the IRS.
The IRS requires you to keep all your expenses records and filings for a minimum of three years. You should be aware that should they conduct an audit and a pattern emerges then you may be investigated even further back in time. Don’t just shred your papers every three years!
Lower income – lower risk of IRS audit
Reading the popular media you may be under the impression that IRS agents like to have a good lunch with major companies’ Chief Financial Officers and let them off lightly thanks to the quality of their hospitality yet like to really go after the little guy working hard to make his or her way in life. This isn’t the case.
According to CNBC, “People who make under $200,000 face a less than 1 percent chance of being audited. The reason is partially because of IRS budget cuts in the last few years. If you earn more than that $200,000, the rate jumps to 4 percent. Even if you make $1 million or more, your odds are still only slightly more than 12 percent.”
That means according to the IRS figures if you earn less than $200,000 you have 1/12th the chance of an audit of someone who takes a million dollars a year, and even they won’t necessarily be hit more than once a decade. Ultimately the IRS is into profit maximization and those making a million dollars a year are going to be more profitable than your Ordinary Jo or Joe who takes $100,000 a year. It makes sense to go after the big guys and less so for the little guy.
You may be audited randomly so the IRS can benchmark certain expenses in your line of business. In order to spot errors in tax returns with its computer system the IRS needs a set of benchmarks for a given trade or profession. Its computer system will assess several thousand randomly chosen tax returns in every grouping just to get averages on claims.
If you are a self-employed art dealer these random bench-marking audits may show that you will typically spend 15% of your gross income on travel. If you are a home-based freelance journalist you may have a high telephone bill for interviewing and networking – the IRS bench-marking audit system will establish that proportion of your income and average it out across all home-based freelance journalists.
What usually leads to an audit by an IRS agent is when your claim is significantly above or below a given benchmark. One year you the art dealer might spend 30% on travel – if you’re honest this is fine but you may get a letter from the revenue service asking for evidence for your unusual travel expenses that year.
There are certain rules around each claim. Did you make charitable donations significantly over 5% of your income in a given year? While some people are known philanthropists – Microsoft founder Bill Gates or the Getty family are notable here – you can expect a letter from the IRS if you have done as these people have.
One common trigger is where a person dips into their IRA pension – perhaps they are in financial difficulty or they may want something special ahead of retirement. In dipping into their IRA they can make mistakes as it is such a complex area of tax law.
Getting the right advice
If you have a tax advisor you will be less likely to make mistakes in your filings. Tax advisors know the ways of this world and their job is to both minimize your exposure to tax as well as minimize the risk of an audit yielding significant repayments to the IRS. A good tax advisor should save you more in taxes than their annual fee. This is not to say you will not be audited – someone earning a million dollars a year almost certainly will be paying someone to file their taxes – but it still pays for the little guy to have a similar system in place to save cash and too much of a sweat when the tax man comes knocking on your door.
The takeaway – it’s not the end of the world
Not everyone can navigate their way through the bureaucracy of tax filings. It isn’t easy. The IRS is after correct payments and isn’t into prosecuting people who have made errors. Especially if you have an accountant or tax advisor who guides you about how to reduce taxes or IRS then you will know the right information. It should be a fairly quick and simple exchange of letters and emails – and hopefully a minimal repayment of errant taxes at the end.