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IRS Audit! The Big White Envelope in the Mail

Over 15 years as a professional tax preparer, writing over 200 returns each year.

For years, you've done the same things on your taxes and no one's questioned it. You've taken the same deductions as your co-workers without incident. Or something unusual came up but you were certain you handled it correctly.

Then the large white envelope arrives. Perhaps even two of them, if you're married and file jointly. The Department of the Treasury. Internal Revenue Service. Asking you to prove, demonstrate, explain.

Remind yourself: Except for a tiny number of people who actively commit fraud, the IRS isn't out to get anyone, and doesn't want to put anyone in jail. It's expensive to put you in jail. The IRS prefers to receive money, not spend it. They want you to pay what they think you owe.

Do not ignore this letter. If it tells you to call the auditor, do so. You can always ask for a postponement but if you ignore them, they can arbitrarily find you at fault and impose hefty penalties. If the letter asks you to fax your response, it will provide a list of the paperwork desired and the date by which the reply is expected.


Why Me?

Let's take a moment to look at how your return was chosen for this honor.

The first possibility is the easiest to deal with: the IRS has been notified of income through a third party, and they can't find it on your tax return. The W-2 or 1099 might have been left off in error, you might not have received it, or you might have reported it on a different line than the IRS was expecting. This type of error usually generates a CP-2000 letter rather than a prove-something-to-us audit, so it's unlikely to be the sole cause of your big white envelope.

The next possibility arises because every tax return runs through an IRS computer that assigns a statistical score. Scoring is based partly on complexity – more forms allow more opportunity for errors and omissions. Large amounts on certain forms are a concern – Schedule A (itemized deductions) high in relation to income, Schedule C (small business) with large losses or no income, Schedule E (passive and rental income) with high losses or property that appears to be personal-use. Large changes in the return from one year to the next may be a consideration. Opening a new business can trigger an audit because the IRS knows taxpayers don't always handle their start-up expenses correctly.

A third possibility is that your return is somehow connected to another audit. This situation typically arises when you're a member of a partnership or corporation, and the business books are being audited. Similarly, if your tax professional is caught getting fraudulently creative, it's likely that all the returns she did will be audited.

You might be part of a random "compliance audit," in which the IRS asks you prove everything on your return. These are strange when you have a really simple return, but that just proves they can truly be randomly chosen.

The IRS doesn't announce exactly how it determines which returns will be audited, but generally it's triggered by something big, unusual or erroneous.

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Now what?

Next, figure out what is being questioned. The year of the return is in the upper right of the letter. It typically takes the IRS 12 to 18 months to identify returns for audit, so right now they are probably looking at your 2016 return, filed in 2017. Once the 2016 catches the interest of the IRS, they can also decide to include the year before and year after. For most tax return errors, the IRS has a three year window in which an audit can be initiated.

The text of the letter will tell you if the audit is correspondence (by fax or letter) or in person (at either your location or the nearest IRS office). It will also tell you which forms or items are under review, and an outline of what the auditor wants to see.

Dig out your copy of your tax paperwork. If you can't find the return itself (and the auditor will ask you for a copy), you can request a transcript (for free) by calling 1-800-908-9946 or a full copy ($50 fee per copy) by mailing in Form 4506. Requests for a transcript can also be made through the internet, , though recent hacker activity on the site has forced the IRS to limit this service. Transcripts don't look like a tax return, and may not have what you need to help you reconstruct your documentation. Try to keep your important tax papers in a secure place for at least three years -- it's easier to read!

Supporting documents are up to you. If you can't find them, you'll have to begin reconstructing them. The IRS considers "contemporaneous" (timely) records the best, but will strongly consider reconstructions, reprinted receipts, and Google-aided mileage calculations. Make copies of everything and never leave originals with the IRS.

Should I hire a CPA?

Taking a neutral party, who understands the IRS-speak, has some advantages. A Certified Public Accountant or an Enrolled Agent (an IRS designation for a tax preparer who has demonstrated a certain depth of knowledge) isn't as likely to get upset when the IRS questions the veracity of your documentation. The CPA / EA may be able to suggest things you didn't think of, which may help offset any damage the auditor does. At the least, the CPA / EA should remind you not to offer information, but to answer only the questions that are asked. A CPA / EA may even suggest that you not go to the audit at all, if you are too emotional about it. Taxpayers don't lose money by taking a CPA / EA to an audit (except perhaps the professional's fees), but many have paid the IRS too much for not having an adviser along.

The IRS keeps a list of Enrolled Agents on their website, and CPAs can be found in your phonebook or by recommendations by friends.

When the audit is done

The IRS has closed your audit. You either had a no-change result (congratulations! - you proved everything to the auditor's satisfaction), your income and / or tax went down (it does happen occasionally), or your income and tax went up.

If you owe the IRS any tax, you also owe them interest, and possibly penalties. You might be able to get out of any penalty if you haven't had any changes to tax returns in the previous three years. The auditor may not be able to make this decision himself. As to paying the IRS, you will be allowed to set up an installment plan, which you'll also be charged an administrative fee for -- up to $225. Direct debit from your bank account is the preferred installment method these days. Depending on the amount owed, the IRS will usually allow five years to pay it off. Interest will continue to accrue, and future tax refunds you might have will be taken as payment towards the agreement, until it's completely paid.

If the amount is too large for you to pay off in ten years, the IRS will consider an offer in compromise. These are not as easy to get as those "pennies on the dollar" tax resolution places make it sound, and you pretty much have to be bankrupt to get one approved these days. If you need to go this route, find a reputable and experienced CPA to assist you with the mounds of paperwork you'll be required to file.

Win or lose, if your tax return is changed during an IRS audit, your state return is likely to change too. Most states say it's your obligation to file an amended return, but you'll find that the IRS communicates with state taxing authorities. If your income went up, the state will send you a bill for additional taxes. Penalties and interest, too, dating back to the original filing date of the return.

Video: Your Guide to an IRS Audit

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