The IRS uses computer systems and other resources to determine which taxpayers and tax returns to examine. An audit can be conducted based on unusual numbers that don’t meet statistical averages from other tax returns, or they can be flagged by computer software, IRS employees, or third parties tipping off the IRS to possible misdeeds by a taxpayer. These exact nature of these “audit flags” are confidential to the taxing authority and change as the economy and business patterns change over time. If the IRS sees one of these red flags suggesting a problem with a tax return, the tax return may be selected for further examination and the taxpayer may be required to substantiate or prove that the claimed deductions from income (“expenses”) are legitimate and qualify for deduction against income.
An audit can be done in several different ways. First, there is what is considered a “correspondence audit” in which the IRS sends a letter to the taxpayer requesting proof of a specific item or set of items in the tax return. The second is an “office audit” in which the IRS requests that the taxpayer come to the IRS office and meet with an auditor to go over certain areas or specific items on a tax return. A third method that is frequently used is a “field audit”, in which an auditor goes to the home or place of business of a taxpayer to examine certain aspects of a tax return. A correspondence audit is conducted by mail or fax, or even online under some circumstances. The other two audits require a face-to-face meeting.
Taxpayers are entitled to be represented by an attorney or other tax professional in an audit meeting. In fact, it is possible for the taxpayer to avoid ever meeting the auditor in most cases if they are represented. To represent a taxpayer before the IRS, it is necessary to meet certain requirements and qualify under the terms of IRS Circular 230.
In all of the various types of audit, the taxpayer is first notified with a letter and a request is made for information regarding a specific part of the tax return, usually an expense that is claimed that may not fit the standard pattern or may be unusual in its amount or nature. No matter how the audit is conducted, it is often a painful and expensive experience.
The most invasive and difficult type of IRS audit is the Taxpayer compliance measurement program (TCMP). This examination is much more comprehensive than average and it covers all aspects of the taxpayer’s financial affairs. Taxpayers are selected on a random basis for a TCMP audit to get comparison data on overall taxpayer compliance issues. If you are unlucky enough to be the subject of a taxpayer compliance measurement program audit, it is even more important to have the support of a tax professional in responding to the requests of the auditor.
Because the IRS can examine a tax return for three years from its date of filing, or up to six years if there is more than a 25 percent change anticipated, it is important to keep documents that can support or “substantiate” expenses used to offset income reported on a tax return. We generally recommend keeping all of this documentation for a period of at least 7 years after the date the return was due or actually filed, whichever is later.