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5 W's of an IRS Audit: What You Need to Know

taxes

Now that the initial tax return filing deadline has passed, most taxpaying Americans have become less stressed about the annual obligation to comply with the federal and state income tax laws. And for those who have filed extensions, the stress is ever present -- at least until October 16, 2017 -- regarding their calendar year 2016 returns.

But as we fast approach the "dog days of Summer," did you know we have reached that time of year in the Internal Revenue Service (IRS)  life-cycle when auditing of previously filed tax returns ramps up? But don't stress!  Because knowledge is power, we're providing you the 5 W's (Who - What - When - Where - Why) about the IRS audit to help you understand and prepare for the process.

WHO: The "Audit Lottery"
So you come home after a long day at work, open your mailbox, and find that dreaded IRS letter that states, "Your return has been selected for audit." Your immediate reaction might be, "Why me?" 

In its 2016 Data Book, the IRS noted that it audited just over one million individual income tax returns in fiscal year 2016 (from October 1, 2015 through September 30, 2016). Returns audited represented approximately 0.7 % of annual returns subject to examination. The IRS noted that this annual audit percentage was the lowest it has been for more than 10 years.

Coincidentally the IRS also noted that its enforcement budget for the comparable fiscal year had decreased by more than $100 million. Historically, my recollection is that the IRS has audited just less than 1 percent of individual returns annually.

Given the number of returns voluntarily filed each year, many taxpayers gain some unjustified confidence in the "audit lottery," thinking that their returns will always fall within the 99 percent of returns not audited. For many taxpayers, this confidence is justified; however, for those few taxpayers that actually pay attention to such statistics, chances are they will be audited in some form or fashion at some point during their adult lives.

WHAT: Types of Audits

One means of lessening the stress around an IRS audit, is to better understand the various forms of audits and what one can expect to happen during the course of an audit. The mission, purpose, operating and organizational structure of the IRS is documented in the Internal Revenue Manual ("Manual").

Part IV of the Manual provides insight and understanding of the audit process and how an audit is to be conducted by an Examining Agent. Although this may seem too technical for the average taxpayer, a brief overview and understanding of the direction given to Agents in conducting examinations can greatly lessen a taxpayer's stress. It is too detailed to go into in this writing, but I encourage you to review Part IV as you prepare for your audit.

The  Computerized 'Matching' Selection Process
Now it's important to understand how one's tax return is selected for examination. Over the years, the IRS has increasing relied on computers for selecting returns for audit. For those reading this blog that have been filing returns for several years, you probably recall that the IRS has increasingly required and relied on employers, financial institutions, the Social Security Administration and other third-party payors to report income and other payments electronically by means of W-2 forms and various Form 1099's.

Over the years the expansion of digital commerce has led to an expansion of Form 1099 reporting: Form 1099-B (Proceeds from Broker and Barter Transactions), Form 1099 - S (Proceeds from Real Estate Transactions), Form 1099-K (Payment Card and Third Party Network Transactions), and Form 1099-C (Acquisition or Abandonment of Secured Property and Cancellation of Debt),  to name but a few. With this increased ability to capture information and have it in a digital format, the IRS has been able to deploy "artificial intelligence" techniques and increase its timeliness and capacity to compare data submitted by payors and reported voluntarily by taxpayers.

This automated process of information "matching" (Information Return Processing System) creates a listing of returns that have inconsistent reporting of information, usually resulting in a letter or "correspondence audit" seeking additional information to clarify the discrepancy and noting the likely audit adjustment and related additional taxes that may be payable should the information the IRS has prove to correct.

It should be noted that the IRS will also notify taxpayers through this matching process if the taxpayer reported a different amount for withholdings, prior year tax payment credits, or estimated tax payments. If a refund is due, the taxpayer will be directed to advise if the overpayment should be refunded or credited to the current year's tax payments.

The DIF and UIDIF Scoring Process
All filed returns are evaluated through a digital scanning process known as the Discriminant Function System or "DIF." With DIF, each return is given a numeric rating indicating the potential for adjustment or change.

Also, returns are evaluated for their potential of having unreported income. This computerized process is known as the Unreported Income Discriminant Function ("UIDIF"). This analysis involves comparing reported income with life-style spending or expenses. This process makes assessments of a tax filer's ability to live the life style determined based on the income reported. 

WHEN:  Assignments to Examining Agents
Upon completion of these matching and scoring processes, information is provided to regional IRS management for further assessment and possible assignment to Examining Agents. In addition to the above mentioned automated techniques, the IRS also uses more "traditional" approaches to determining when to send a case to an agent, such as selecting returns filed by related parties to a transaction or reporting event.

If one party to a transaction has reported it incorrectly, there is a likely chance that other parties to the transaction have made similar errors. Also, it is well known that the IRS listens to whistleblowers and considers many factors before pursuing an examination solely on such information. But incriminating information can lead eventually to examination upon validation of the information.

Lastly, returns are selected at random. It is not uncommon for such return examination results to be used by the IRS in calibrating its automated DIF and UIDiF parameters.

Once selected for examination, the taxpayer will be initially notified by U.S. mail  (i.e., a letter), that their return has been selected for audit. After this initial contact by mail, subsequent discussions arranging details about the audit may be conducted by telephone with the identified Examining Agent.

WHERE: Audit Options
The IRS has three principle means for conducting audits: by correspondence, by office visit, or by a field visit. Field visits typically occur at the taxpayer’s home, place of business, or the tax professional's office engaged by the taxpayer for assistance.

WHY: The IRS Mission
A taxpayer being examined has many rights as disclosed in the published IRS information releases. And remember,  the purpose of the examination is to determine that the reported tax is correct and in keeping with U.S. tax laws. The mission of the IRS is to "Provide America's taxpayers top-quality service by helping them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all." 

If you keep the IRS mission in mind, fully prepare for the examination by assembling supporting documentation, as well as engage the IRS agent with a cooperative attitude, the examination should move along quickly and will likely be less stressful. Be sure to confer with a tax professional who has been "around the block" with examinations to guide you on all aspects of the examination process.



A final note on Tax Scams: There are several variations of phone-related tax scams out there, preying on unsuspecting Americans. The IRS almost weekly issues a news release ("IRS Newswire") cautioning taxpayers about the many emerging variations on these schemes. Remember: Any payment for taxes due, resulting from an audit adjustment, will be known at the closing of the audit; and arrangement for payment will be known at that time.

When callers represent themselves as IRS employees and demand immediate payment over the telephone, you should assume it is a scam. Whenever the IRS requires an immediate payment, it is done in person by a visit from a well-credentialed IRS Agent a situation you want to avoid!

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