Monday, March 30, 2009

The Audacity of the Audit


Is there a more frightening word in the English language? Probably not, for most taxpayers. In the most recently completed tax year, the IRS used the audit to collect more than $23.5 billion, a 37% increase over the previous year. High-income earners and small business owners are especially suspect when it comes to audits.

But first things first. What is a tax audit? Well, it is basically a thorough examination into the background and substantiation of income, expenses, deductions, and credits claimed on an individual or business tax return. It is conducted to ensure that items claimed on the return are correct and can be proven through documentation (e.g. receipts, etc.).

There are a couple of types of audits, each with its own rules.

By far the most common type of audit is called a Correspondence Audit. Generally, the IRS will send you a letter, requesting more documentation from you. You provide the documentation, and can go on with your life. Though it can easily result in an increased tax liability.

The IRS also conducts Office Audits, where you are asked to bring documentation to the nearest IRS office for a review and interview. The IRS agent will request specific documentation. This is where deductions will be challenged, and if fail to back it up, you can end up with a much higher tax bill. Be sure you only bring what is asked, otherwise, you’re opening yourself up for an expanded audit. If you have it with you, the IRS agent will want to see it.

The Field Audit will strike fear in the hearts of even the most conscientious taxpayer. This usually occurs in more complex tax situations, such as with a business entity. In this case, the IRS agent will want to fully review your return and verify each and every deduction and income source. This can be a lengthy, involved process and can end up costing you thousands in increased tax liabilities. I guess the one piece of good news is that you are allowed to decide when and where to schedule the meeting. I recommend picking a neutral location — preferably in your tax professional’s office, since they probably know more about tax laws than you do.

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