What Should You Do When You Get an IRS Audit Notice?

First, when you get a notice of a tax audit from the Internal Revenue Service (IRS), don’t panic. Although your return was among the less than 1 percent selected for audit, most examinations are limited in scope and have no criminal implications.

Over 70 percent of audits are handled by correspondence through the IRS office, while the rest require face-to-face interaction. In general, it is wise to have your preparer or other tax professional deal with an IRS tax audit. They will recognize the issues and can best present the facts and argue the law if there are issues of statutory interpretation.

Most IRS audits arise from one or more entries on the tax return that are “unusual” or “unlikely.” Such determinations are made by an IRS formula. But while a computer program selects returns for tentative examination, a real IRS agent reviews them and makes the ultimate determination of whether to audit based on the likelihood of errors.

On individual nonbusiness returns, the most common issues involve the earned income credit, employee business expenses and charitable contributions. The IRS believes that the “ordinary and necessary” business expenses of virtually all employees are paid by the employer and questions most of these deductions. The IRS is also suspicious of large cash donations by individuals of modest means, as well as the value claimed on many donations of property.

On individual business returns, a frequent issue involves purported losses from self-employment where the IRS often finds hidden personal expenses or those relating to the individual’s full-time job. The IRS may contend that the activity is a hobby or not for profit.

Some audits arise from examinations of related parties or from a random selection of all returns under the National Research Program (NRP). These random audits are rare, but they are usually very extensive. Their published purpose is to gather information and determine which groups of taxpayers are most likely to be noncompliant.

Audits may also arise from “information” being reported to the IRS, perhaps by a disgruntled former employee or ex-spouse. As is the case with all examinations, this audit process can lead to criminal investigation and prosecution. The number of cases referred to Criminal Investigation Division is small; in fiscal 2016, the IRS initiated only 3,395 criminal probes. Any audit with possible criminal implications should be directed to an experienced criminal tax attorney for direction; he or she will manage the examination, often remaining in the background. 

As the numbers indicate, however, most audits involve only issues of dollars and cents and are resolved at the agent level. Where issues remain, they can be appealed administratively. The right to an in-person appeals conference, largely taken away in 2016, has been generally restored after a practitioner outcry. In appeals, outstanding issues will typically be resolved on their individual merits and based on litigation risks. The few cases not settled in appeals go into the court system where taxpayers prevail on only a small percentage of matters.

Accordingly, recognize that the best opportunity to resolve a matter is at the examination itself. Good preparation with the aid of an experienced professional will likely lead to the best possible result.

—David S. De Jong is an attorney and certified public accountant, practicing law with the Rockville firm of Stein Sperling Bennett De Jong Driscoll, PC. If you want additional information on this area of tax law, see our tax overview.