Tax audit

What Is a Tax Audit?

A tax audit is an examination of an individual's or organization's tax return by a tax authority, such as the Internal Revenue Service (IRS) in the United States. The primary purpose of a tax audit, which falls under the broader financial category of Taxation, is to verify the accuracy of the reported income, deductions, credits, and overall tax liability. The aim is to ensure that taxpayer declarations align with tax laws and regulations. If discrepancies are found during a tax audit, additional taxes, penalties, or interest may be assessed.

History and Origin

The concept of a centralized federal tax collection agency and the need for oversight arose in the United States during the Civil War. President Abraham Lincoln signed the Revenue Act of 1862, which established the office of the Commissioner of Internal Revenue and levied the nation's first income tax to help fund war expenses. This temporary measure imposed a 3% tax on incomes between $600 and $10,000 and 5% on incomes over $10,000.¹⁷ While the income tax was repealed in 1872, it was revived by the Wilson Tariff Act of 1894, only to be ruled unconstitutional a year later.¹⁶

The modern federal income tax and, by extension, the formal practice of tax audits, solidified with the ratification of the 16th Amendment in 1913. This amendment granted Congress the power to collect taxes on incomes without apportionment among the states.¹⁵ Since then, the IRS has evolved its audit practices to enforce federal tax law, primarily by examining returns with the highest potential for noncompliance. The agency uses various methods, including risk-based scoring mechanisms, data-driven algorithms, third-party information, and whistleblower tips, to identify returns for audit.

Key Takeaways

• A tax audit is a review of a taxpayer's financial information and tax return by a tax authority to verify accuracy.
• The IRS in the U.S. uses data analysis and risk assessment to select returns for audit, rather than solely random selection.
• Audit rates have generally declined across all income levels in recent years, though certain groups, such as very high-income earners and those claiming the Earned Income Tax Credit, may face higher rates.¹⁴,¹³
• Taxpayers have rights during an audit, including the right to representation and the right to appeal audit findings.
• The objective of a tax audit is to ensure tax compliance and correctly assess any owed tax.

Interpreting the Tax Audit

A tax audit is typically not an accusation of wrongdoing but rather a mechanism for the tax authority to verify the accuracy of a tax return. If an audit results in a "no change" outcome, it means the original tax liability or refund amount remains as filed. If the audit uncovers discrepancies, the tax authority may propose adjustments to the tax liability. The severity of the adjustment can vary significantly based on the nature of the errors found, ranging from minor mathematical corrections to substantial re-assessments stemming from misreported adjusted gross income or unsubstantiated deductions.

Taxpayers should interpret an audit request as a formal inquiry requiring a precise and timely response. Providing accurate documentation and clear explanations is crucial. The audit process allows the tax authority to ensure that the proper amount of revenue is collected, while also giving the taxpayer an opportunity to clarify their financial situation.

Hypothetical Example

Consider Jane, a self-employed graphic designer, who filed her tax return for the previous fiscal year. She reported significant business expenses, including a large home office deduction and substantial travel costs for client meetings. Several months later, Jane receives a letter from the IRS initiating a tax audit of her business expenses.

The letter requests detailed documentation for her home office deduction, including floor plans and utility bills, and proof of her travel expenses, such as receipts for flights, hotels, and mileage logs. Jane gathers her records, including organized digital copies of her financial statements, receipts, and a log of her business mileage. During the audit, the IRS auditor reviews the documentation. They determine that while Jane's travel expenses are well-substantiated, her home office deduction calculation was slightly off, leading to a minor understatement of her tax liability. Jane agrees with the adjustment, signs the agreement, and pays the small additional tax owed, concluding the audit process.

Practical Applications

Tax audits are a core component of tax administration globally, serving several practical applications:

• Ensuring Tax Compliance: Audits act as a deterrent against non-compliance and help enforce tax laws by identifying underreported income or overstated deductions.
• Revenue Generation: By uncovering errors and fraud, audits help governments collect billions in additional revenue that would otherwise go uncollected. For instance, audits of high-income taxpayers have shown to yield significantly higher returns per dollar spent. From 2010 to 2014, audits of taxpayers in the top 0.1% of the income distribution yielded approximately $6.29 for every dollar spent in audit resources, significantly more than audits of lower-income taxpayers.¹²
• Data Collection and Policy Insights: Audit findings provide valuable data for tax authorities to understand common areas of non-compliance, assess the effectiveness of current tax laws, and inform future policy adjustments. The Government Accountability Office (GAO) regularly reports on IRS audit trends and makes recommendations for improvement, for example, regarding audits of high-income individuals.¹¹
• Fairness and Equity: While controversial at times, audits aim to ensure that all taxpayers pay their fair share, preventing those who might attempt to evade taxes from gaining an unfair advantage over compliant citizens. Audit rates have declined across all income groups since 2010, though the decline has been greater for high-income taxpayers.¹⁰ Certain government programs, like the Earned Income Tax Credit, are often subject to higher audit rates due to their complexity and susceptibility to errors.⁹

Limitations and Criticisms

While essential for a functioning tax system, tax audits have limitations and face criticisms:

• Resource Intensity: Conducting audits, particularly complex ones involving large corporations or high-net-worth individuals, requires significant resources, including skilled personnel and advanced technological tools. Historically, staffing decreases at the IRS have led to lower audit rates across all income levels.⁸
• Taxpayer Burden: Audits can impose a significant "audit burden" on taxpayers, involving monetary and non-monetary expenditures regardless of their compliance level. This burden can be particularly magnified for lower-income taxpayers who have fewer resources.⁷ Research suggests that while burdensome audits can deter non-compliance for those who evaded, they may paradoxically lead to decreased compliance for initially compliant individuals due to negative perceptions of the process.⁶
• Perceived Unfairness: Criticisms sometimes arise regarding the selection process for audits, with concerns about disproportionate targeting of certain income groups or demographics. For example, some analyses have indicated higher audit rates for low-income taxpayers claiming the Earned Income Tax Credit compared to middle-income taxpayers.⁵
• Limited Impact on Intentional Evasion: Some academic studies suggest that while audits can improve tax compliance among taxpayers who make inadvertent mistakes, they may show little or no improvement in future compliance for those who deliberately evade taxes.⁴
• Impact of Economic Conditions: The effectiveness and focus of audits can be influenced by broader economic conditions and government funding levels, which impact the tax authority's capacity to conduct comprehensive examinations.

Tax Audit vs. Tax Evasion

A tax audit is a formal process undertaken by a tax authority, like the IRS, to examine a taxpayer's financial records and tax return to confirm accuracy and adherence to tax laws. It is a procedural tool for verifying reported information.

In contrast, tax evasion is an illegal act of intentionally misrepresenting one's financial affairs to reduce or eliminate one's tax liability. This typically involves deliberately failing to report income, claiming fraudulent deductions, or concealing assets. While a tax audit may uncover instances of tax evasion, the audit itself is the investigatory process, whereas tax evasion is the unlawful act that the audit seeks to identify. If evasion is discovered, it can lead to severe [penalties], including fines and imprisonment. Tax compliance is the goal, and tax evasion is a violation of that compliance.

FAQs

What triggers a tax audit?
Many factors can trigger a tax audit, including discrepancies between your reported income and third-party information (like W-2s or 1099s), unusually large deductions for your income level, consistent reporting of losses from a hobby business, or claiming certain credits like the Earned Income Tax Credit. The IRS also uses data analysis and risk-based scoring to identify returns with the highest potential for errors.

How will I be notified of a tax audit?
Generally, the IRS notifies taxpayers of a tax audit by mail. They will typically send an official letter, not initiate contact via phone call or in-person visits without prior written notice. Be cautious of scams that mimic IRS contact via phone or email.

What should I do if my tax return is audited?
The most important step is to remain calm and organized. Review the audit notice carefully to understand what information the IRS is requesting. Gather all relevant documentation, such as receipts, invoices, and [financial statements], to support the items being questioned. It is often advisable to consult with a tax professional, such as an accountant or tax attorney, who can help you understand the process and represent you.

Can I appeal an audit decision?
Yes, taxpayers have the right to appeal an audit decision if they disagree with the IRS's findings. The IRS has an independent Office of Appeals that aims to resolve tax disagreements without needing to go to court.³ You can typically submit a formal written protest outlining your position or, in some cases, request a small case conference for amounts less than $25,000.²,¹ This process also applies to other disagreements, such as a denied Offer in Compromise or certain [penalties].

What are the potential outcomes of a tax audit?
There are three main potential outcomes: "no change" (meaning the original [income tax] return is accepted as filed), "agreed" (you agree with the IRS's proposed adjustments and pay any additional [tax liability]), or "disagreed" (you do not agree with the proposed adjustments and can pursue an appeal or litigation).