Audits Conducted by Mail/Fax (Correspondance Audits)
Mathematical Corrections
The IRS uses computers to find mismatches between names and social security numbers, earned income credit qualifications, filing status issues, estimated tax and withholding tax errors, estimated tax assessments, late filing penalties and interest, or any number of other issues. Sometimes these audits require an appointment and sometimes the IRS simply recalculates your tax return with a new tax balance due, including interest and penalty assessments. These corrections are frequently wrong, but the IRS acts as if they couldn't possibly err.
Income Document Matching – Automated UnderReporter (AUR)
IRS computers match all pertinent forms, such as 1099s, W-2s, and K-1s relating to your name and social security number to what you report on your tax return. If the numbers do not match your tax return, an audit is almost certain. Usually you will get a CP2000 notice that itemizes the discrepancies in Part 1 and will have a calculation of proposed additional tax, penalties, and interest in Part 3. Sometimes the IRS sends a preparatory initial notice called a CP-2501. It is the same notice, but without the proposed amount due that will be sent on the CP2000 notice a few weeks later. In either notice, there will sometimes be an additional audit item hiding among the “boiler plate” paragraphs of Part 2.
IRS Special Projects
Every year the IRS identifies a certain industry or three that it wants to focus on. One year it will be waiters, and another year it might be airline personnel or taxi drivers. Usually the group selected is known for certain abuses.
Random
The IRS scores every tax return with a DIscriminate Function (DiF) score. It is based on secret calculations they use to identify income tax returns with the highest likelihood of tax increase in an audit, and the amount of additional tax that might arrise from audit. The DiF score increases for various items (such as Schedule C or auto expenses), and decreases for other items (such as using a paid preparer). IRS classifiers review high DiF score tax returns and some are selected for audit. As with most audits, usually only one Schedule will be audited, and usually only 2 or 3 items.
Additional Documentation Requests
The IRS might just be requesting that you submit an additional form or schedule that they feel you omitted. Sometimes they are right and sometimes they are wrong, but it is best to try and submit what they are requesting right away. The IRS can disallow credits and deductions even if they lost your paperwork or are otherwise at fault and will then issue a bill for the balance due, including interest and penalties.
Office Audits - Face-to-Face
National Research Program (NRP)
This audit is the most intrusive by its very nature, as it thoroughly examines tax returns line by line. So, for instance, if you claimed a child as a dependent, you will need to provide the birth certificate to prove that the child is yours and proof that the child was actually living with you in the tax year being audited. It continues on from there, often through every line on your income tax return.
DiF Score
Some returns selected randomly [using the DIscriminate Function (DiF)] score trigger an in-person audit instead of a correspondence audit. The office audits are the ones that have received the most publicity in the last several years. Congressional pressures on the IRS and an increase in funding have dramatically increased audits. This type starts with a telephone call or letter from the IRS. The telephone call is a tactic designed to get you to volunteer information long before the face-to-face meeting. They already know many of the answers to the questions they are asking; they just want to see how truthful you are. During the audit appointment, the IRS will examine items on the tax return in question and, they might also ask to review one or two other tax returns. A Revenue Agent auditor will almost always request multiple tax returns and might exam your Financial Status (see below), while a TCO (Tax Compliance Officer) will usually stick to just one year, and is less likely to question you about your deposits.
Field Audits - Home (or Office) Invasion
Financial Status
If the auditor needs to come to your home or place of business, then it almost always be a real Revenue Agent, and will almost certainly audit your bank deposits, standard of living, and cash & bartering habits to see if they can add additional income to your tax return. Auditors use public records and statistical data to trace spending and changes in wealth to try and show that you might have unreported income. Some of these records include tax returns for all open years, credit reports, property tax records, business license applications, motor vehicle records, 1099 information, currency transaction reports and SEC filings. Due to perceived abuses of these techniques, Congress limited their use in 1998, stating that the IRS cannot use financial status or economic reality techniques unless they have a reasonable indication that there is a likelihood of unreported income. The law does not define "reasonable indication," but you can bet that they will use these methods only when it is likely to cause additional tax.
Criminal Investigation
If the person auditing you is a Special Agent, then hire the best tax attorney you can afford; the IRS might think that they can put you in jail. Special Agents will identify themselves as such, and they carry hand guns. The IRS publishes a list called the Dirty Dozen outlining the scams that they are most focused on.
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