What Is IRS Audit?
An IRS audit is an official examination or review conducted by the Internal Revenue Service (IRS) of an individual's or organization's tax return and financial records. The primary purpose of an IRS audit is to verify that the income, deductions, tax credits, and other financial information reported comply with federal tax laws and that the correct amount of tax liability has been assessed and paid48. This process falls under the broader financial category of taxation, serving as a critical tool for the IRS to maintain the integrity of the U.S. voluntary tax compliance system46, 47.
History and Origin
The concept of auditing tax returns has evolved alongside the U.S. federal income tax system. While the IRS itself was established in 1862, the modern income tax, and thus the systematic auditing of tax returns, gained prominence after the ratification of the 16th Amendment in 1913, which granted Congress the power to levy taxes on incomes from any source. The necessity for an agency to ensure proper reporting and collection grew with the expansion of the tax base and complexity of tax laws. Audits became a fundamental method for the government to verify self-reported tax information and address the tax gap—the difference between taxes owed and taxes paid voluntarily and on time. 45The Government Accountability Office (GAO) has historically reviewed and reported on the IRS's collection processes and effectiveness in managing unpaid tax debts, highlighting the long-standing challenge of ensuring compliance.
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Key Takeaways
- An IRS audit is a formal review of a taxpayer's financial information to ensure compliance with federal tax laws.
43 Audits can be initiated through various methods, including statistical analysis of returns, discrepancies with third-party information, or related examinations.
41, 42 There are primarily three types of IRS audits: correspondence (by mail), office (in-person at an IRS office), and field (in-person at the taxpayer's home or business). - Most IRS audits are resolved without any change to the original tax return, or with agreed-upon changes; taxpayers have rights, including the right to appeal findings.
*40 While audits can be daunting, a strong emphasis on accurate record-keeping and a prompt, organized response can significantly facilitate the process.
39## Interpreting the IRS Audit
An IRS audit is not necessarily an accusation of wrongdoing; it is a mechanism for the agency to verify the accuracy and completeness of information provided on a tax return. The IRS selects returns for audit through various methods, including random selection, computer screening comparing returns to "norms" for similar returns, and matching information reported by third parties (such as W-2s and 1099s) against the taxpayer's filed return. 37, 38Discrepancies between reported income and information from other sources often trigger an examination.
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When interpreting an IRS audit notification, it is crucial to understand the type of audit initiated, as this dictates the scope and required response. 35A correspondence audit, typically conducted via mail, often focuses on specific items or discrepancies, while an office or field audit involves more in-depth reviews and potentially in-person interviews. 34The notification letter will detail the specific issues under review and the documentation required. 33Responding promptly and thoroughly with accurate financial records is essential.
Hypothetical Example
Consider Jane, a self-employed graphic designer, who receives a letter from the IRS initiating a correspondence audit for her most recent tax return. The letter specifically questions a large deduction she claimed for home office expenses and asks for supporting documentation.
Jane's steps to respond:
- Review the Notice: Jane carefully reads the IRS letter to understand the exact items being questioned and the deadline for her response.
- Gather Documentation: She compiles her financial records related to her home office, including utility bills, mortgage interest statements, receipts for office supplies, and a log of the square footage used exclusively for business.
- Prepare a Response: Jane writes a clear letter explaining how she calculated the home office deduction, referencing her supporting documents.
- Submit Information: She makes copies of all documents for her own records and sends the requested information to the IRS by the due date.
In this scenario, by providing clear and organized documentation, Jane demonstrates that her claimed deduction was legitimate, potentially leading to a "no change" outcome from the IRS.
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Practical Applications
IRS audits serve as a critical component of federal tax administration, ensuring fairness and compliance across the tax system. They have practical applications in:
- Verifying Taxpayer Compliance: Audits are fundamental to ensuring that individuals and businesses accurately report their income, expenses, and other financial details in accordance with tax laws. This promotes confidence in the overall tax system.
31 Revenue Collection: By identifying underreported income or overstated deductions, IRS audits help the government collect taxes that are legally due, contributing to federal revenue. In fiscal year 2023, the IRS closed over 580,000 tax return audits, resulting in billions of dollars in recommended additional tax.
30 Deterrence of Non-Compliance: The existence of an IRS audit program acts as a deterrent, encouraging taxpayers to be accurate and honest in their filings, even if the actual audit rate is relatively low. For example, only 0.2% of individual income tax returns filed for the 2020 tax year faced an audit, according to IRS data.
29* Updating Audit Selection Models: Insights gained from audits, particularly those from programs like the National Research Program (NRP) or Taxpayer Compliance Measurement Program (TCMP), help the IRS refine its Discriminant Information Function (DIF) system, which scores returns for audit potential, thereby improving future audit targeting.
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For individuals and businesses, the practical application lies in maintaining meticulous financial records and seeking advice from a tax professional or Certified Public Accountant (CPA) when preparing complex returns or facing an audit. The IRS encourages taxpayers to keep records for at least three years from the filing date, as this is the general statute of limitations for audits.
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Limitations and Criticisms
Despite their necessity, IRS audits face several limitations and criticisms. A primary concern has been the declining audit rates across all income levels in recent years, largely attributed to reduced IRS staffing and funding. 23, 24This decline may impact the agency's ability to effectively enforce tax laws and close the tax gap. 22For instance, audit rates for taxpayers with incomes of $200,000 or more have seen significant decreases, as these complex audits often require substantial staff time and expertise.
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Another criticism involves the potential for bias in audit selection. While high-income earners are generally audited at a higher rate, low-income taxpayers who claim the Earned Income Tax Credit (EITC) also face disproportionately higher audit rates compared to other low-to-middle income groups. 19, 20This can place a burden on vulnerable populations, even though many EITC audits are initiated due to errors in claiming the credit rather than intentional tax fraud.
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Furthermore, the Government Accountability Office (GAO) has highlighted weaknesses in the IRS's internal controls and data protection, raising concerns about the security of taxpayer information during the audit process and beyond. 16, 17While the IRS has made efforts to improve, ongoing issues with contractor oversight, monitoring capabilities, and technical controls, such as data encryption, remain areas for improvement. 15The complexity and time required for some audits can also be a significant burden on taxpayers, especially field audits that involve extensive review of financial statements and records.
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IRS Audit vs. Tax Compliance
While closely related, an IRS audit and tax compliance represent distinct concepts within the realm of taxation. Tax compliance refers to the act of adhering to all applicable tax laws and regulations, ensuring that all required tax forms are filed accurately and on time, and that the correct tax liability is paid. It is the taxpayer's responsibility to maintain proper financial records and fulfill their tax obligations.
An IRS audit, conversely, is a specific enforcement mechanism employed by the IRS to verify a taxpayer's adherence to tax compliance. It is a review or examination process that occurs after a tax return has been filed, to ensure the information reported is correct. 13Therefore, while an IRS audit assesses past tax compliance, it is not tax compliance itself. A taxpayer can strive for perfect tax compliance but still be selected for an IRS audit due to various factors, including random selection or discrepancies flagged by automated systems.
FAQs
How am I notified of an IRS audit?
The IRS typically notifies taxpayers of an audit by mail. They will not initiate an audit by telephone, email, or social media. The letter will include information about the tax year being examined, the specific issues, what documents are needed, and how the audit will be conducted (by mail or in person).
10, 11, 12### How far back can the IRS audit my tax returns?
Generally, the IRS can audit tax returns filed within the last three years. However, if a substantial error is identified, they may go back up to six years. There is no statute of limitations if a fraudulent return was filed or if no return was filed at all.
7, 8, 9### What are my rights during an IRS audit?
As a taxpayer, you have several rights outlined in the Taxpayer Bill of Rights. These include the right to be informed, the right to quality service, the right to pay no more than the correct amount of tax, the right to challenge the IRS's position and be heard, and the right to appeal an IRS decision in an independent forum. You also have the right to representation by a tax professional such as a Certified Public Accountant or attorney.
4, 5, 6### What happens if I disagree with the audit findings?
If you disagree with the proposed changes from an IRS audit, you have the right to appeal the decision within the IRS itself. If a resolution is not reached at the administrative appeal level, you may generally take your case to the U.S. Tax Court, U.S. Claims Court, or a U.S. District Court.
2, 3### Can an IRS audit result in a refund?
Yes, while an IRS audit often aims to identify underreported taxes, it is possible for an audit to conclude with no change to your tax return or even result in the IRS determining that you are due a refund.1