Income Tax Audits and Appeals

Facing an audit by the IRS or the California Franchise Tax Board is such a stressful experience that it has become something of a cliché. When most people hear the word “audit”, they picture a harassed and stressed-out taxpayer being pursued by a pitiless bureaucracy. They think of sleepless nights filled with worry about an uncertain future. They think of red tape, hassles and most of all, an expensive penalty. Unfortunately, for many people facing an audit, this isn’t far from the truth.

The federal government and the State of California have a wide variety of powers to ensure taxpayer compliance with their respective tax codes. The tax audit is one of these powers, along with liens, garnishment, forfeiture, and in the most extreme cases, criminal penalties. In this article, we’re going to look at the tax audit process at both the federal and state level, explaining how it works and what the best way to proceed is if you are faced with an audit.

Why Am I Being Audited?

In general, an audit is triggered by one of two reasons. First, the taxpayer in question exhibits attributes that grab the attention of the IRS. In many cases, the attribute that interests the IRS the most is income. The IRS naturally wants to maximize the return on the investment of time and money that it puts into any audit. Therefore, the more income that you have, the more likely it is that you will be targeted for an audit. For example, 16% of all individuals with an income in excess of 10 million dollars were audited in 2014. Likewise, almost 11% of all individuals with income between 5 million dollars and 10 million dollars became the subject of an audit in 2014. Compare that to the slightly greater than 0.5% of individuals with an income between $50,000 and $75,000 who were audited by the IRS that same year.

In addition, the IRS is also likely to be more interested in individuals who run a small business or a business that deals mostly in cash, have offshore investments, have big changes in their income, or who file zero income or fail to file tax returns altogether. If you fall into one of these areas, you face an elevated risk of being audited.

The second thing that triggers an audit is the IRS finding a problem with your tax return. All income tax returns are scored for the potential for errors and problems based on the experience that the IRS has had with similar returns in the past. Those returns that are given a high score will be scrutinized more closely and some will be selected for audit, again based on the likelihood that the IRS will be able to recover further tax revenue as a result.

What Type of Audit Will Occur?

The IRS typically uses three different methods when conducting an audit. The least severe of these is the correspondence audit. In a correspondence audit, a taxpayer is asked to provide additional information and documentation to support their tax return. While a correspondence audit is relatively benign, the failure to provide documentation that adequately satisfies the IRS will result in an escalation of the audit process.

The next type of audit is the office audit. In an office audit, a taxpayer is required to travel to meet with an auditor at an IRS field office. An office audit is usually a sign that the IRS feels the potential errors and irregularities on a tax return justify spending additional resources in investigation. While any audit is serious, an office audit should not be taken lightly. If justified, the IRS can go back through six years of tax returns in an attempt to find fraud. If fraud is found or is admitted to, the costs and penalties levied can quickly become prohibitive.

The last and most severe type of audit is the field audit. In a field audit, IRS agents come directly to your home, place of business, or both to not only assess the books, but to also assess the life style of the taxpayer, his house, cars, boats, etc, his or her business, and day-to-day operations of the business as a whole. A field audit is extremely intrusive and has the highest potential for the IRS to find fault, levy additional fines and penalties, and in some cases, to trigger a criminal tax evasion investigation.

Finally, the IRS and state tax agencies like the California Franchise Tax Board routinely share information. This means that if the IRS finds potential errors in a tax return, they will likely share this information with a state level agency like the FTB. As a result, a taxpayer facing an IRS audit may soon find themselves facing a state tax audit as well.

Can I Appeal the Results of an Audit?

Once an audit is complete, the IRS prepares a report outlining all of the changes to a return as well as an itemization of the taxes, interest, and penalties involved. This report is forwarded to the taxpayer along with a letter advising the taxpayer that they have 30 days from the date of the letter to appeal the results of the audit.

If the amount the IRS claims you owe is $25,000 or less for any one tax period, you can initiate an appeal by filing IRS Form 12203, Request for Appeals Review. Alternatively, if the amount you owe is greater than $25,000, you must prepare and file a formal written protest. This protest must include specific information including your contact information, a list of the proposed items in the audit that you disagree with, the reasons for your disagreement, the law and facts that support your disagreement, a “penalty of perjury” statement, and your signature. Failure to include any required information may delay your appeal or cause it to be dismissed altogether.

Once your appeal has been filed, your case will be forwarded to the IRS Office of Appeals. Response times from the Office of Appeals depend on the nature of the case and the time needed to review the file involved. On average, you can expect to hear from an Appeals employee within 90 days of filing your appeal.

The next step will be an informal appeals hearing in which you present your case to the Appeals Officer in charge of your case. Any settlement of your claim will be negotiated at this time. The success of this negotiation process depends on how well your appeal is prepared and presented. While you are entitled to represent yourself, a seasoned income tax lawyer who understands the audit process, as well as the process of appealing the adverse effects of an audit, can save you a significant amount of time and money.