Posted by The TaxAdvocate Group, LLC

The IRS Tax Audit Procedure, Rules & Guidelines

The IRS Tax Audit Procedure, Rules & Guidelines

The IRS and state tax departments can perform tax audits. The following information is based on IRS tax audits, but keep in mind that most state audit processes and procedures are quite similar to those of the IRS. The purpose of the tax audit is to verify that the declared tax is correct. Most of the time, when Uncle Sam selects your return for an audit, statistically, there is a problem based on the numbers you provided. Being selected doesn't usually mean there is a problem. Sometimes you may need to receive a refund after the audit, or the IRS will accept your tax return as it is.

How the IRS selects tax returns for an audit

The IRS uses several different factors when selecting which returns to audit (Triggering Audit Flags). Most tax audits are computerized. The IRS has several computer systems that perform various types of performance analysis that perform statistical analysis to classify tax returns based on the likelihood that they are accurate. The IRS also selects audits based on other non-IT analyses; all methods are described below.

  • Discriminant Function System (DIF): The Internal Revenue has a computer program called the Discriminant Function System that notes every tax return. This score is called the DIF score. A score is a number that statistically determines the likelihood that the tax return is correct. The higher the number assigned to the tax return, the more likely it is that the tax return will be verified. The IRS does not share details of how exactly its system works, but it is believed that several hundred variables are weighted and that deductions and exemptions are considered the most important.

  • Unreported Income Discrimination Function (UIDIF): is a second computer program used by the IRS that analyzes factors other than the DIF system. The purpose of this program is to assess the performance of your undeclared income potential. This system classifies people according to the ratio between expenses and income. It is primarily trying to determine if a person is spending more money than they earn and, therefore, likely have other income that they don't report to the IRS. Sometimes people have years of low income, and it triggers an audit for them, but most of the time, it can be easily explained to an auditor.

  • Information Return Processing System (IRP): this is a third-party computer system used by the IRS that stores large amounts of data received from third parties who are required to report income from taxpayers such as employers, banks, commercial intermediaries, social security administration, and other institutions that are required to report taxpayer information to the IRS. For example, your employer must report how much you paid your employees during the year to the IRS. The IRS will then run its matching system to ensure that the individual taxpayer reports anything that has already been provided to the IRS. The IRS can identify people who are unlikely to report their income and conduct an audit with this system.

  • Incriminating documents turned over to the IRS: In rare cases, tax returns will be reviewed for verification based on information obtained by the IRS for the purpose of identifying participants in tax evasion transactions. The IRS sometimes orders the courts to disclose the promoter's information to the IRS. This information may identify individuals who have participated in promoters' tax avoidance programs.

  • Related Entity Audits: If the IRS verified another tax return and that involved return transactions with other taxpayers, such as business partners or investors, and there was a problem with that return, and other affiliated persons likely have such an entity/individual; therefore, it is possible for the IRS to subsequently select the relevant tax returns for verification.

Types of audits, once selected.

Once the IRS determines that it would want to go further and learn more about your tax return, it will send you a letter stating that your return has been selected for auditing. Below are the different audit methods used by the Internal Revenue.

  • Correspondence Audit: This is the most prevalent type of audit, and it is done by post. The IRS generally requires specific documentation to support certain elements of the tax return.

  • Field audit: This is when the Internal Revenue wants to come to your home, workplace, or office to perform the audit. This is the least form of audit and is only used if the person or company being audited earns more than $100,000.

  • Office Audit: This is when you need to go to an IRS office to meet with an IRS auditor. The IRS will determine the time and specific documents you wish to take along for support.

What happens after an IRS audit?

After the audit, you will receive or submit IRS Form 4549, the IRS inspection report, and show the proposed changes to tax liability. Form 4549 will provide a clear explanation of the changes made. The report will say that you haven't made any changes or are entitled to a refund (no action is required on your part, you won! congratulations) OR that the changes have been made and you owe more taxes, interest, and penalties. Once you've received it, you have two options: you can approve the IRS findings or choose not to accept them, each of which is described in more detail below.

Approval of Audit Results

If you accept the proposed changes, you must sign and submit a copy of the report along with IRS Form 870. IRS Form 870 is your consent to the proposed tax adjustment. After signing the form, you acknowledge that you have a fiscal deficit as well as the additional tax penalties and interest, which are also indicated in the audit report. If you owe the IRS more taxes than you can pay in full, you can request payment through a repayment plan. The payment plan you use will be established by how much you owe and how much you can pay each month.

Disapprove Audit Results

If you disapprove of the results of the audit report, you have 30 days to do the following:

  • Send any additional documents you wish the IRS to consider

  • Request a discussion of the results with the examiner (this can be done, and additional information can be sent for review).

  • Discuss your case with the group or senior manager.

  • Request an appeal - If you disagree with the proposed changes and have not clarified your disagreement with the reviewer, an appeal may be a good option.

You will have thirty days to consider the proposed changes after receiving the review report. If you don't respond within the stipulated time frame, the IRS will send you a notice stating that your case is considered undisputed, and if you only have 30 days to appeal, otherwise the IRS findings will be final.

Bottom Line

The Internal Revenue audit statistics show that your chances of getting audited are minimal (less than half of 1% (just 0.45%) of individual statements audited in 2019, up from 0.59% in 2018 and a lot less than in 2010, when they were 1.11%). 

Overall, audits have dropped, and the IRS budget and staffing constraints are likely to reduce your chances of being audited in the near future. However, if you are audited, you know how they work.



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