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Key Takeaways
- IRS audits are not as common as they are made out to be, with only about 1% of filers being audited.
- The IRS uses a system called the Discriminant Information Function to determine which returns are worth auditing.
- There are two general types of tax audits: correspondence audits and in-person audits. Correspondence audits are the more common of the two, and most people who receive a letter from the IRS only need to respond to a few questions.
- Low to moderate incomes do not protect taxpayers from being audited, with the IRS increasing its number of audits in the past few years.
IRS audits
An audit is arguably the most dreaded outcome of the tax filing process, and the situation carries with it some unsettling mystique. The standard nightmare has Internal Revenue Service agents with badges showing up on your doorstep, or the agency—seizing smorgasbord-style—the bulk of your personal assets. But audits contrast greatly from their thriving myths.
“Audits are something most people should not be afraid of,” says Sandy Zinman, tax committee chairman for the National Conference of CPA Practitioners. “A lot of times the government just doesn’t want to do these audits.”
In fact, Zinman says, one of the most enduring tax audit myths holds that an audit is a common occurrence. He says audits are generally “a lose-lose situation” for the IRS because they require a lot of resources and because of the negative image audits project onto the IRS.
“Historically, only about 1% of filers get audited. That’s a real small percentage,” said financial adviser Thomas Jensen, owner and managing partner of Vaerdi LLC in Portland, Oregon. The IRS did not respond to questions regarding specific details of its auditing process, including its total number of audits.
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, Jensen said.
Although the IRS audits only a small percentage of filed returns, there is a chance the agency will audit your own. The myths about who or who does not get audited—and why—run the gamut.
Myth: Be very afraid of an audit
The looming myth out there suggests the audit process is something to be desperately feared. But there are two kinds of tax audits: the "correspondence audit" and the in-person audit. The correspondence audit is the more common of the two IRS audits and some may not even realize it's an audit.
- Most people who receive a letter or notice from the IRS only need to respond to a few questions.
- In many cases, the IRS will ask you to simply verify some of your information or send an additional tax payment.
The other kind is the in-person audit. An IRS agent will request an appointment with you to review certain financial information.
“A lot of times it’s a very simple problem to resolve,” Zinman said. “What we’ll see is someone sold some stock during the year and forgot about it (when filing taxes) or didn’t even know what the stock was worth. So they can get a letter asking for information and actually get a refund because they lost money on the sale.”
Myth: You will have to meet with an IRS agent if you are audited
The majority of audits are triggered by missing information in tax returns, such as wages from a job, interest from a bank account, or income from selling an investment. Income like this is usually reported on a W-2 or 1099 form that you should receive at the beginning of the year.
The IRS also gets a copy of the W-2s and 1099s that taxpayers receive so that their computers can automatically compare the information on your tax return to what the IRS has in its files.
When your tax return and the IRS' files don't match up, it can trigger an audit. However, these encounters with the IRS are rarely face-to-face because the first and easiest step is for the IRS to mail you a notice, usually a CP2000 notice, asking about the discrepancy.
When responding to the notice, you can indicate whether you agree, partly agree or disagree with the information in the notice and the resulting change that the IRS is proposing to your tax return.
If you disagree, you can provide more information or submit an amended tax return that addresses the IRS' concerns. If you agree with the IRS, you can send them a payment with your response or set up a payment plan.
There are options to meet with an IRS employee about your situation by scheduling a meeting at a local field office. But, it's often far easier to resolve your issues by timely responding to their inquiry.
Myth: Those with low to moderate incomes don't get audited
Jensen said the IRS has ramped up the number of audits it does in response to the country's economic woes. That means people should not think they're in the clear if they do not earn a lot of money.
“(The IRS) is doing audits across the board, for all incomes,” said Jensen. “Over the last few years they’ve been hiring more people for that.”
Still, he reiterates that even though the IRS has increased its level of auditing, the number is a very small percentage of the returns filed.
TurboTax Tip:
Concern about audits should not deter taxpayers from claiming deductions or credits they are entitled to. Audits are not done immediately, with the IRS abiding by a statute of limitations typically of three years after the due date of the return including extensions or for up to three years after filing if you filed late.
Myth: Filing for certain deductions or credits increases the chance of an audit
Many people avoid taking certain credits and deductions—denying themselves tax advantages to which they are entitled—because they believe or have heard that taking them will make them more susceptible to an audit, says Clegg.
“I saw many thousands of people who said, ‘No, I don’t want to claim my daughter because she lived with my ex,’ or would not claim certain education credits out of fear," Clegg said. "Fear of an audit would cause people to just hand money over (to the government), money they were entitled to.”
Home office deductions are a big inspirer of audit fears, says Jensen.
“I hear a lot of people say, ‘If you take a home office deduction you’re going to get audited.’ These days, most or a lot of people have home offices,” Jensen said. “For years, I’ve had a home office, taken the deductions and I’ve never had an audit.”
Zinman said 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. He cited the example of a recent client. The individual had experienced financial hardship, dropping from a $350,000-salary job to a $7,000-a-year income and, subsequently, lost his home.
“He is worried about getting audited,” said Zinman. “I told him not to worry about it. There’s nothing to fear. The information is true, and it would come down to just explaining the situation to the IRS.”
Myth: Audits are done immediately
The IRS abides by a statute of limitations of three years after the due date of the return, says Clegg. For “substantial errors,” the IRS maintains it can go back six years and recommends you keep most records at least that long. The experts agree: If an audit is going to happen, it will occur in the latter half of the three-year time frame.
“Audits generally always happen two years after you file,” Zinman said. “You’ve got to understand all of the hundreds of millions of people who live in this country and (who) file returns, not to mention corporations. It takes a while for all of these filings to get done and the computer to get through this process.”
A deeper understanding
Although these are some of the most popular myths, experts say plenty of other misguided beliefs about audits run rampant, some even with their own regional flavor. The bottom line is to understand what the process is all about.
“You know, the American way is to work hard and pay the least amount of taxes that you can. It’s the same even for the people who work at the IRS,” Zinman said. “With filing taxes, you’re making an assertion on your return. You’re basically telling a story. You’re putting forth your story and if you’re questioned, the IRS is saying, ‘We read your story and we want you to show us where you got this info.’
“But people shouldn’t worry,” he said. “They’re not going to just come take all your money. They have a long process to go through before that. You have a lot of rights. If you owe the money, they’ll 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.”
State Audits
So many of the myths about auditing are quite narrowly focused on the Internal Revenue Service, suggesting that the IRS is the only entity that matters. That's a big-time mistake says Tim Clegg, a budget software developer and retired financial coach. Many people, he says, get through the IRS only to get “tangled up” with their state returns.
“More of the heartaches I’ve seen have had to do with state returns,” Clegg said. “The IRS is a pussycat compared to a lot of these state (tax revenue) agencies. No one out there is hungrier for revenue than the states. They’re broke and working hard to get money. And they will not be as friendly, by and large.”
He recommends tax filers be at least as diligent and careful when filing their state returns as they are with their federal tax returns.
If you live in one state and work in another, Clegg noted, you must file returns for each state.
TurboTax has you covered
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