The US system of income tax is based upon the voluntary compliance of taxpayers. Each taxpayer is responsible for reporting all worldwide income combined with taking the proper deduction expenses. Most taxpayers receive wages on a Form W-2 and the IRS gets a copy of this Form. So, if the taxpayer does not report this income the IRS may send the taxpayer a notice of the deficiency and propose an additional tax assessment. One of the most heavily audited groups are the self-employed and small businesses. These taxpayers tend to report their business income and expenses on Schedule C of their Form 1040. The IRS is looking for unreported income and overstated expenses.
An audit examination typically begins with a letter from the IRS or state taxing authority. While a taxpayer can be randomly selected for examination, typically it is based upon IRS computer software to detect that a return has unreported income or overstated expenses. There could be a related examination that led to an audit. Also, the IRS may receive information from an informant or a foreign financial institution. To fully preserve the taxpayer’s rights and to ensure the best outcome, it is best to seek legal representation as soon as the taxpayer receives the initial examination letter from the IRS or state taxing authority. Frequently, taxpayers who try to represent themselves before the IRS make a bad situation worse leading to larger tax assessments.
The audit examination will focus on the review of the taxpayer’s records to substantiate the tax return. There are three types of audit examinations:
- via mail,
- at an IRS office, or
- at the taxpayer’s home, business or lawyer’s office.
Generally, the IRS can only audit tax returns for the last three years. However, this period extends to six years if the tax return omits more than 25% of the gross income or over $5,000 of foreign income. In the case of unfiled tax returns or fraudulently filed tax returns, the IRS has no time limit to examine these years. However, the IRS has a policy of not going back more than six years for audit examinations.
At the end of the examination, the auditor will issue a Revenue Agent Report. The taxpayer is given 30 days to accept the report or to file a protest with IRS Appeals which is independent of the auditor. If the taxpayer does not reply within 30 days of the Revenue Agent Report, the IRS will issue a Notice of Deficiency. In this case, the taxpayer has 90 days to file a petition with the U.S. Tax Court which is not affiliated with the IRS.