you should almost always cooperate with an audit by mail. unless the documents requested are lost or nonexistent, promptly send copies to prevent an escalation.
in most cases an audit delayed is an audit well played; in most cases the more time an audit drags on, the better the result. auditors are under pressure to close files, and need your cooperation to do it; time creates pressure. the drawback is that interest and penalties are growing—but this may be insignificant next to the damage caused by a large audit bill.
if you get a phone call from the irs before getting notice by mail, politely tell them you want notification in writing to make sure this a legitimate audit; refuse to discuss anything until you get a notice in the mail. always ask for the furthest date available so you have enough time to get your records in order; a month or two is common; the so called taxpayer bill of rights requires that you be given a say in this process. schedule the appointment on the last day of the week toward the end of the month, in late morning—just before the auditor’s lunch break—or late afternoon. friday afternoons are ideal, especially if a three-day weekend is coming up. then, call a day or two before and postpone the audit; you can get one, or possibly two, postponements for almost any reason.
on the day of the audit, leave some records at home, then ask for time to furnish them later. auditors have come to expect missing records and will routinely allow taxpayers two weeks or more to get them. at the audit you should expect to spend 1 - 4 hours with the agent, don’t offer anything voluntarily or try to be too helpful. if the auditor asks for something you don’t think pertains to the audit, ask them to explain specifically how it relates to the audit year; the IRS cannot require you to furnish data unless it is directly related to the year under audit.
unreported income is the auditor’s number one concern in a field audit. there are four common methods the agency uses to probe for income:
net worth method: if your net worth has their calculations are wrong or that your net worth increased due to nontaxable factors.
expenditures method: the irs totals up all of your known and estimated expenditures for the year and compares the result with your reported income. if you spent more than you claim you earned, the irs will attribute the difference to unreported income. try to show that the irs didn’t add and subtract correctly or that money you spent was from nontaxable sources, such as loans, gifts, inheritances or prior accumulations.
bank deposit method: this is the agency's favorite indirect method of proving unreported income and is always used by field auditors. the irs simply tallies the deposits made in all of your bank accounts and compares the total with your reported income; if you have deposited more than you claim you earned, the agency will attribute the difference to unreported income. do your own bank deposit analysis before the audit, there can be any number of explanations when deposits exceed taxable income—loans, redeposits of bad checks, transfers between accounts, inheritances and gifts received, sales of assets, etc.
mark-up method: if you are in a retail or wholesale goods business, the agent may look at your sales, cost of goods sold, and net profits. if these numbers are much lower than for similar businesses, the irs will fill in the gap by asserting unreported income. ask the agent for the source of statistics, the irs may be comparing you to a completely different type of business. if this is not the case, explain why your business underperformed compared to similar businesses—it is a new business or was closed several months, your major customer or supplier went bankrupt, or any of a thousand other reasons.
avoid holding an audit at your home or business, the "bill of rights" permits small business owners to refuse an audit on their business premises if an audit would virtually shut the business down.
if the agency holds the audit at your place of business or home, don’t make it too comfortable. before agents arrive, remove any items that might cause suspicion; if a tour your of your business is required, don’t let the agent wander around on her own—stay by her side.
the tax code gives the auditor wide latitude and authority to pry into your financial affairs. the basic tools are the interview, summons, irs and other government files, and contacts with third parties. along with your audit notice may come a separate form called an "information document request", a written solicitation of records or other papers either in your possession or accessible to you. typically, bank statements and canceled checks are listed; if what is being requested may seriously hurt or even incriminate you, see a tax attorney before responding. if the agency doesn’t get information from you voluntarily it may issue a summons this orders you to appear before the auditor to answer questions and to bring certain documents. you can raise legal objections to a summons, including: self-incrimination, that the summons is vague, broad or unduly burdensome or that certain items are protected by a legal privilege—such as the attorney-client privilege. if you don’t comply, the irs may bring you before a federal court judge in a summons enforcement proceeding.
During an office or field audit a few scenarios deserve special attention.
What happens when:
You don’t give the auditor information that she has requested.
The Auditor has three choices:
Drop it: You’d be surprised how many auditors back off or are forgetful. They are working on many other cases. If they have most of the information requested from you, they may let it slide.
Go further without your cooperation and issue Third Party Summons: Auditors can call, write, or issue summonses to third parties such as banks, employers, business associates, and anyone else. You must be notified in writing when a third-party summons is issued and you have a right to object. But the bottom line is you can’t stop a third-party summons.
Access IRS files: Your previous tax returns, audit reports, and tax account history can be accessed by auditors. The auditor might first ask you for this information.
Seek other government and public records: Auditors have direct computer access to the Treasury Enforcement Communication Systems, or TECS, computer, which has all kinds of data on you. TECS is not public, so you can’t be sure what is in the files. The auditor can also access your Social Security Administration, passport office, and postal service records. Auditors can view local and state public records showing ownership of vehicles, boats, airplanes, real estate, and business entities you might be involved in. Private databases such as LexisNexis and credit reporting agency files contain a wealth of personal data about all of us, and are accessible to auditors.
Make Third-party Contacts: Auditors can send letters or call or visit businesses and people who have dealt with you, such as the secretary of a church where you claimed a charitable contribution. First, they must give you Notice 1219A, Notice of Potential Third Party Contact. You can legally object to these contacts, at least in theory. If the auditor reveals personal or financial information about you to the third party, you can file a complaint with the IRS that your right to privacy has been violated by an unauthorized disclosure.
Issue an examination report anyway: The auditor can issue the report based on the information she has and her estimates for the missing income or expense data. By far, this is the most likely consequence of your not cooperating with an auditor.
You don’t show up.
If you choose not to show up for the office or field visit, the IRS will take one of three actions:
Conduct the audit without you:The IRS may also examine tax years not covered by the initial audit. The auditor may look at all open years—returns due and filed within the past three years. And if the auditor suspects serious misdeeds, he may go back as far as six years.
Contact you again: You may be contacted by the auditor and asked why you are not cooperating. Eventually, she’ll give up and issue a report, finding unreported income or disallowing most of your deductions and exemptions. A tax bill will follow.
Serve a summons and order you to appear. A summons is a legally enforceable order and you could be held in contempt of court—and even jailed—if you ignore it. See a tax attorney before making your next move.
Should I talk to the Auditor during the audit?
Auditors are trained to listen and to create silence. They examine records without speaking, with the hope that you will talk away. Auditors get damaging information from taxpayers who blurt out answers to questions that weren’t asked. The six best responses to a question posed by an auditor are:
“I don’t recall.”
“I’ll have to check on that.”
“What specific items do you want to see?”
“Why do you want that?”
Again, don’t say more unless absolutely necessary. Also don’t lie to, or mislead an auditor, and don’t offer any favors to the Auditor.
The Auditor tells me If you can’t prove a deduction in writing, it won’t be allowed. Courts have repeatedly told the IRS that taxpayers can’t be expected to keep flawless records. Tax regulations allow taxpayers, within limits, to offer oral explanations, use approximations for some expenses, claim expenses under $75 without receipts, and reconstruct records when the originals are missing. Gaps due to missing documents may be filled by reconstruction—a process by which you rebuild lost or destroyed records.
Can I Negotiate With an Auditor?
An auditor has no power to change your tax return. She can only propose tax changes to you. An auditor fully realizes that if you don’t go along with her proposals, you may appeal in most instances or go to tax court. In fact, the IRS’s guiding principle for auditors is to close examinations with your consent to keep you from clogging up the appeals office and tax court. Because an auditor’s performance is judged on her closing ratio —how many examination reports are accepted by taxpayers—you are in a perfect position to negotiate with an auditor. As soon as the audit begins, tell the auditor that you have heard that audits usually produce adjustments. Say that you would appreciate it if she finds them quickly and gets it over with so you can go about your business. Many auditors have a personal tax adjustment level, which they know will satisfy their manager. But the more time an Auditor spends on your case the more invested she’ll be in the results of her time.
When the auditor completes her work, you will be handed or mailed IRS Form 4549, an Examination Report. It shows changes proposed to your tax liability for the years under audit. The report also provides a brief explanation for each change. You have three choices after you receive the examination report.
Agree. The IRS hopes you will sign, date, and return a copy of the report along with IRS Form 870, Consent to Proposed Tax Adjustment. This is referred to by the IRS as an agreed case. By signing Form 870, you agree to the immediate assessment of the tax deficiency found, plus any penalties and interest listed on the examination report. You have up to three years to pay on a monthly basis. Interest and late payment penalties still accrue on the unpaid balance. Interest and penalties on late tax payments get added on. It is okay to tell the auditor that you will just wait until a bill comes from the IRS campus center computer and then decide how to pay.
Argue. Examination reports are not cast in stone until you sign off. If you want to fight the report, call the auditor. Tell her what findings you disagree with. Ask what additional proof it would take to get her to change the report. Request 30 days to get a missing document or reconstruct a record. If your new documentation doesn’t help, ask the auditor for a copy of her work papers. These are the notes the IRS requires an auditor put in a file. Work papers should explain and justify any changes made to a tax return. Don’t be surprised if the auditor refuses to show you her work papers. If she refuses, tell her you know you are entitled to see them under the Freedom of Information Act, and if she won’t show them to you, you will make a formal request for them.
Do nothing. You don’t have to respond to a proposed examination report at all. If you ignore it, the auditor may call, or in a month or two you will receive something called a 30-Day Letter. This is your formal notice that your case is considered “unagreed” and that you have 30 days to start an appeal or the findings become final. To contest the audit results now, you must file a petition in the U.S. Tax Court within 90 days. If you don’t, the examination report becomes final—your right to contest the audit without first making full payment has ended.