The best way to deal with any IRS audit is to be prepared. The best way to prepare for the IRS audit is to review your circumstances for the years under audit and to gather records for those years in advance. This may sound difficult, but it is not. The effort you put in to preparing for the audit will usually be well worth the effort. This can save you fees, if you hire a tax professional and it can help reduce any IRS audit adjustment and penalties and interest. 

Identify the Reason for the Audit

Your first step to prepare for the audit is to try to assess why the IRS is interested in your tax return. This assessment will help you determine the probable focus of the audit and alert you to what records you need to locate or create. 

Random Selection

The IRS picks tax returns for audit randomly. Some tax returns, even those with no issues, can get pulled for an audit because of this random selection. 

When an IRS auditor is assigned a random audit, they will review the return to identify any potential issues or areas of concern, known as “surveying” the tax return. If there are potential issues or areas of concern, the IRS auditor will start the audit process by setting the case up in their systems and sending out the audit opening letter. 

IRS auditors often focus on large, unique, or questionable items reported on the tax return or items that were unreported on your tax return. Common audit areas also include charitable deductions, mileage deductions, and omitted or mismatched income. It is impossible to predict whether your tax return will get pulled for audit or not, but most audits are due to one of these reasons. These issues are what the auditor is likely to ask you about during the audit. 

You should review your tax return and see if you omitted any income. You do this by examining your bank and financial account records and noting any deposits or large transfers. If you add these amounts up, do they line up with the amount of income reported on your tax return? You should also look for any large tax deductions or credits reported on your tax returns. These items are likely to be reviewed on audit. You should be prepared to pull these records if the IRS auditor asks for them. 

Computer Screening

The IRS relies on computer systems to assign scores to tax returns. Returns with high scores for either of these systems are more likely to be chosen for review.

The Discriminant Information Function compares tax returns based on similar factors, like income or job. Tax returns reporting financial data that differs significantly from established peers get a high DIF score. These tax returns are likely to be selected for audit.

The Unreported Income Discriminant Function, on the other hand, scores for the potential of unreported income, It compares your spending to your earnings. High spending and low earnings can trigger an IRS audit.

The Information Returns Processing System is also used to identify which tax returns to review. This system compares tax returns with data received from third parties, such as employers, brokerage firms, financial institutions, the Social Security Administration, and other entities required to report taxpayer information to the IRS for matching. Discrepancies can trigger an IRS audit. 

When a tax return is audited, the reasons are provided to the auditor to guide their review. Luckily, the IRS auditor will usually tell you about this issue in their opening letter or the opening meeting. This will help you focus on what is needed to prepare for the audit. 

Related Audits

When the IRS conducts an audit and finds a significant adjustment, it may expand the audit scope to other tax years or related parties. Suppose an investor, business partner, or any person or entity you or your business is involved with has their tax return audited. In that case, your tax returns may also be audited. This type of related audit may be assigned to the same IRS auditor. Regardless, the focus of the audit is usually on the issue that triggered the audit. The IRS auditor will usually not tell you about the related audit. However, you can get a sense of it from discussing this topic with the auditor. This can help guide you in preparing for the audit. 

Refresh Your Memory As to the Facts

We file tax returns each year, which puts the IRS a year behind. It, therefore, may take the IRS one or two years to decide to audit your tax return. As a result, the IRS is now two to three years behind. This is when you will receive the IRS’s audit notice. This delay in starting the audit can make it difficult for you to recall what you were doing during the years under audit and make it more difficult to obtain records.

Your circumstances may have changed in the past few years. You may have changed jobs, and you may have moved across the country, your family may have increased or decreased in size, etc. With an office audit and a field audit, the IRS will expect you to know your circumstances for the years under audit. If it is an individual audit, this includes knowing where you lived, what you were doing for a living, and your family situation. You may need to refresh your memory about the approximate dates of where you lived, when you changed jobs or businesses, and when you were divorced or had children. For a business audit, you need to know what the business was generally doing, its significant items of income and expenses, how its records were kept, etc. 

Gather and Create Records

With this background information, you can take stock of what records you have. You can also make a list of documents you need to obtain. 

The IRS audit will likely focus on your income and your expenses. For income, unless your audit is a single issue, as with a CP2000 or correspondence audit, the IRS is likely to want to review your bank and financial account records. You should make a list of any bank and financial institutions you had accounts with during the years under audit. If you do not have the monthly statements, you may want to go ahead and reach out to the bank to get them. You might do the same for any credit card accounts you used to pay for business or rental property expenses. If you filed your tax return as married filing jointly, include your spouse’s bank and credit card records in your requests. You should compare the income (i.e., the deposits) listed on these records and reach those to the income reported on your tax return(s) that are under audit.

For expenses, you should review your tax return and identify the most significant expenses reported on your tax return. You will likely need receipts, canceled checks, and other relevant information for these expenses. Consider getting invoices from third parties for these expenses, if you do not already have them. Having all the documents related to your finances establishes credibility with the IRS and can set a positive tone for the entire audit process. It also allows you to identify any deficiencies and try to fix them before the auditor discovers them. 

You can and should re-create any records that help support tax deductions or credits taken on your tax return. Do not get held up on the idea that the records need recreation. The IRS auditor may note that the records are not contemporary, but they will usually accept them. If they do not, at least you have something to discuss with the IRS Office of Appeals or in court–if it comes to that. 

Consider Prior Years

The IRS audit notice will tell you what tax years are being audited. The IRS audit may not be limited to just that tax year or tax years. The IRS will often expand its audit to include tax returns for prior years. 

The IRS does have some limits on the years it can audit. Generally, the IRS can only adjust a tax return that was filed within the last three years. This three-year period starts on the day your file each tax return. The three-year period can be extended to six years, if the auditor concludes that you understated your income on the tax return by twenty five percent or more. 

There is no time limit, if you did not file the tax return or if you filed a fraudulent tax return. Even in these cases, the IRS will often not go back more than six years. If the IRS does go back further than this, it is often due to a third party having filed an information return indicating that you had significant income in the prior year. This often involves Forms 1099 filed by third parties. 

Even if the audit notice does not include these prior periods, you should be on guard to encourage the auditor not to open the prior years. You should also be prepared to gather and provide records and information for these prior years, if the IRS auditor opens these prior years for audit, sends you a notice to that effect, and requests information for these prior years. 

File an Extension for the Current Tax Year

If you are about to file a tax return for the current tax year, it may be advisable to file an extension to request additional time to file the return. The IRS auditor is less likely to pull just one additional tax year for audit. If the IRS is auditing Year 1 and it is now Year 3, the IRS may be less likely to pull Year 2, if that is all that you have filed in Year 3. If you file Years 2 and 3 before the audit is closed for Year 1, the auditor is more likely to pull Years 2 and 3 for audit. It takes the IRS auditor time and effort to open another tax year. This time and effort may not be deemed worthwhile, if there is only one year to open. This does not guarantee that the IRS auditor will not open the later year, but it certainly decreases the chances that the later year is opened for audit. This can save you a considerable amount of tax and penalties and time and effort for the later year.