With tax day over, the pins and needles now begin for those who are concerned about the dreaded audit.
Are such fears overblown?
“Correspondence from the IRS doesn’t necessarily mean they’re auditing you,” says Abby Donnellan, a CPA and senior tax strategist at Moneta in St Louis. “The first thing to do after you receive a letter from the IRS is to remain calm. Likely they just need some additional information or are sending you an automated letter about your return processing.”
Part of preparing for an audit is realizing that there are multiple types of “audits,” Donnellan says, such as a letter requesting more information or a meeting requested by an agent. “Typically, a letter requesting more information is fairly simple. It can signify that something wasn’t attached to the return when it should have been, or income doesn’t match the income reported to the IRS,” she says.
“The IRS has increased their use of auto-generated notices, and often, these can cause false alarms,” adds Jeff Watkins, a partner at Plante Moran Wealth Management in Denver.
Amid preparers’ general cautions to wealthy clients, hard annual data on IRS audits is open to interpretation. “We know the IRS uses something called the discriminant function system scoring system that assigns a score to returns based on past IRS experience with previous returns,” says attorney Toby Mathis, a founding partner of Anderson Business Advisors and manager in its Las Vegas office.
“The IRS uses a multitude of methods to identify returns for audits,” he adds. “For example, the IRS also uses reported information via W-2, 1099, K-1s and other informational returns to identify returns with missing data. This has nothing to do with the size of the return. The IRS also has a list of abusive transactions that it investigates.”
Mathis says data for the 2020 tax year allows for “some easy observations”:
• The IRS selected 509,917 tax returns for audits.
• Almost three out of four of these were correspondence audits where the IRS mails a request for information to the taxpayer.
• The IRS selected 0.69% of individual returns for audit.
Individual returns showing more than $10 million in income had a 7% audit rate, Mathis says.
According to his research of recent years’ IRS data, a sole proprietor making $100,000 had a 1.6% audit rate, and all individual returns were audited at a rate of 0.4%, including international returns, returns of those making more than $1 million and individuals claiming the earned income tax credit.
As the Tax Cuts and Jobs Act eliminated most personal expense deductions and capped the state and local tax (SALT) deduction, “on your Schedule A, there are now fewer things for the IRS to focus on—medical, which has a huge AGI hurdle, charity and mortgage interest,” says Laura LaForgia, a CPA and managing director at CBIZ Marks Paneth in New York.
“Try to avoid being audited to begin with,” LaForgia says. “Be organized in how you present your information to your accountant. Avoid sending the information piecemeal, such as emailing items one by one. This creates more chances for human error. If your accountant gives you an organizer package or a checklist, use it. Take some responsibility in having your taxes done correctly.”
Donnellan adds, “Currently the IRS is very behind on return processing, so be patient. ... If you call the IRS, sometimes you won’t even get through to a person because of the volume of returns and the lack of workers.”