Tax Audit

A tax audit is the Internal Revenue Service's review of a filed return to determine whether the items on it were reported accurately. The examination power comes from section 7602 of the Internal Revenue Code, headed "Examination of books and witnesses," which authorizes the Secretary to examine any books, papers, records or other data that may be relevant and to summon people to testify under oath.

The naming is worth settling at the start, because both words are the IRS's own. Publication 556 is titled "Examination of Returns, Appeal Rights, and Claims for Refund," and it opens: "The Internal Revenue Service (IRS) accepts most federal tax returns as filed. However, the IRS examines (or audits) some returns to determine if income, expenses, and credits are being reported accurately." So "examination" is the formal term used in the statute and in IRS correspondence, "audit" is the word everyone including the IRS uses in ordinary speech, and there is nothing to correct in either direction. Note that neither word means what "audit" means in accounting, where an audit is an independent opinion on a set of financial statements.

There are three kinds, and they are very different experiences. The IRS splits them first into audits conducted by mail and audits conducted in person, and then names the in-person ones by where they happen. An audit by mail, called a correspondence examination in IRS operational vocabulary, arrives as a letter asking for documents on one or two specific items and is resolved without anyone meeting; the IRS says a taxpayer with too many records to mail can request a face-to-face audit instead. An office audit brings the taxpayer to an IRS office with records for a defined list of issues. A field audit sends a revenue agent to the taxpayer's home, place of business, or accountant's or representative's office, and it is the one that reaches whole-return and business questions. Publication 556 puts the location rule plainly: "Some examinations are handled entirely by mail. Examinations not handled by mail can take place in your home, your place of business, an Internal Revenue office, or the office of your authorized representative." The examiner will try to accommodate an inconvenient time or place, but "the IRS makes the final determination of when, where, and how the examination will take place."

Selection is mostly mechanical. Returns are chosen by computerized screening, by random sample, or by an income document matching program that compares the return against the Forms W-2 and 1099 filed about the taxpayer. A mismatch notice generated by that matching program is the commonest form of contact and is often resolved with one letter. Being selected does not imply an error and does not imply dishonesty.

You are entitled to representation, and the list of who may represent you is set out in the publication itself. A taxpayer may act on their own behalf or be represented by "any federally authorized practitioner, including an attorney, a certified public accountant, an enrolled agent (a person enrolled to practice before the IRS), an enrolled actuary, or the person who prepared the return and signed it as the preparer." That last clause carries an important qualification: a paid preparer who is neither an attorney, a certified public accountant nor an enrolled agent has only limited representation rights, and one who holds nothing but a preparer tax identification number has none at all.

Two protections almost nobody knows about. The first is statutory. Section 7605(b) provides that "No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer's books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary." The second is administrative and narrower: Publication 556 says the IRS "tries to avoid repeat examinations of the same items," and that a taxpayer whose return was examined for the same items in either of the two previous years with no change proposed should contact the IRS to see whether the examination should be discontinued. Raising either point costs nothing and is sometimes decisive.

Third-party contacts require notice. Before the IRS approaches banks, employers, neighbors or customers about a taxpayer's liability, it must give reasonable advance notice, and it must provide a record of who was actually contacted, both periodically and on request. The requirement does not apply to a pending criminal investigation, where notice would jeopardize collection, where notice might result in reprisal, or where the taxpayer authorized the contact.

The sequence is fixed, and each step has a deadline that starts on the date printed on the letter rather than the date it arrives.

1. Notice. The examination begins when the IRS notifies the taxpayer that the return has been selected and identifies the records it wants. Gathering those records before any interview is what makes the rest go quickly.

2. The examination itself. The examiner reviews the records and explains any proposed change. Most taxpayers agree at this stage and the matter closes there. If the IRS proposes no change, it sends a letter saying so, which is worth keeping with the year's tax records.

3. Disagreement inside the office. If the examination took place in an IRS office, the taxpayer may ask for an immediate meeting with the examiner's supervisor. Agreement there closes the case.

4. The 30-day letter. Within a few weeks of the closing conference the taxpayer receives a package containing a letter notifying them of the right to appeal within 30 days, a copy of the examination report explaining the proposed changes, an agreement or waiver form, and a copy of Publication 5. The 30 days run from the date of the letter.

5. Appeals. An appeal goes to the Internal Revenue Service Independent Office of Appeals, which section 7803(e) establishes inside the IRS as a separate office. It is the last stop before the courts and it is free.

6. The 90-day letter. If the taxpayer does not respond to the 30-day letter, or does not reach agreement with an Appeals officer, the IRS issues a 90-day letter, formally a notice of deficiency. From its date the taxpayer has 90 days, or 150 days if the notice is addressed outside the United States, to file a petition with the United States Tax Court. That route is what lets the dispute be heard before the tax is paid: Publication 556 says the District Courts and the Court of Federal Claims "generally" hear tax cases only after the entire tax and penalties have been paid and a refund claim filed.

A hypothetical example of what is actually at stake. An examiner disallows $6,000 of a deduction on Kwame's return. He is in the 22% bracket, so the proposed additional tax is 22% of $6,000, or $1,320, plus interest running from the original due date of the return. Two things follow from the size of that number. Paying it is often cheaper than fighting it if the documentation is genuinely missing, and it is small enough that the free administrative appeal, rather than litigation, is the proportionate response if the documentation exists.

What the process gives a taxpayer

• A written explanation of every proposed change before any tax is assessed, rather than a bill out of nowhere.
• A free administrative appeal to an office that Congress placed outside the examination function.
• A pre-payment forum. Petitioning the Tax Court within the 90-day window means the disputed tax does not have to be paid first. A refund suit is the other route, and the District Courts and the Court of Federal Claims generally hear one only after the tax and penalties have been paid.
• A statutory limit on repeat inspection of the same year's books, and a stated administrative practice of avoiding repeat examinations of the same items.

What makes it hard

• Every deadline runs from the date printed on the letter, so postal delay and a holiday absence eat the response window rather than extending it.
• Interest accrues from the original due date of the return, so a long dispute costs money even when the taxpayer eventually wins on part of it.
• The taxpayer carries the burden of substantiating what the return claimed, which turns a documentation gap into a loss regardless of whether the underlying expense was real.
• The IRS decides the time, place and method, so a taxpayer with a disorganised year cannot simply wait until the records are in order.
• A preparer who holds only a preparer tax identification number cannot represent the taxpayer at the examination, which is often discovered at exactly the wrong moment.