A tax audit is when the Internal Revenue Service (IRS) conducts a formal investigation of financial information to verify an individual or corporation has accurately reported and paid their taxes. Selection can be at random, or due to unusual deductions or income reported on a tax return.
What Can Trigger a Tax Audit?
Audits help to ensure tax laws are being followed by businesses and individuals. To do this, the IRS analyzes and compares taxpayer data with a system called the Discriminant Information Function (DIF) system. The DIF gives every tax return a score and results from this analysis can lead to an audit if any of these is present:
- Incomplete income reporting
- Discrepancies or mistakes on filing forms
- Unusual business expenses like entertainment or large dining bills
- Money in a foreign bank account
- Cash-based or cash-focused businesses like restaurants or small shops
Most IRS audits of individuals are directed at high earners making over $500,000 annually; less than 1 percent of filers have their returns examined. Additionally, self-employed taxpayers are more likely to be audited because their income tends to be less stable and harder to track than wage workers.
Types of Tax Audits
There are four types of tax audits: correspondence, office, field, and a Taxpayer Compliance Measurement Program (TCMP) audit.
The most common IRS audit is the correspondence audit, which accounts for roughly 75 percent of all audits and is the simplest. This is conducted through a letter requesting more information or a notice that requests adjustments to your return to match IRS data.
If the concerns in your filing are too complex for the simple solution, an office audit may be necessary. This is when the IRS calls a filer into an IRS office to conduct an in-person audit to examine issues often related to itemized deductions, business profits or losses, or rental revenues and expenses, and typically takes one day to complete.
Field audits are the most thorough investigation into a return. An IRS agent will visit a taxpayer or business to look through records onsite. This can also include interviews with employees or of the taxpayers themselves.
Taxpayer Compliance Measurement Program (TCMP) audits are used to update the DIF system for the IRS. Every single line of a tax return must be proven with documentation if subjected to a TCMP audit.
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