Although the term audit is most often used when referring to the IRS, in more basic terms, an audit is the process of examining the financial records of a person or business to make sure they are accurate and in accordance with industry best practices.
A company may employ internal auditors who are responsible to make recommendations for streamlining systems and improving operations and controls based on their findings. External auditors provide an independent opinion about the accuracy of a business’s financial records. Publicly traded companies must be externally audited for the benefit of their shareholders.
An audit is designed to provide reasonable assurance that a business’s financial records are free of material misstatement, which is inaccurate information that could mislead an individual using the records in question to make a financial decision. During an audit, the auditor will look for ways to enhance internal controls and will assess the risk of fraud.
Most companies have an audit at least once a year, though large companies may undergo a monthly audit. In addition, an audit is necessary when a company is planning a merger or a sale, seeking outside investors, or applying for a large loan or a credit line.
The CPA conducting the audit will examine the business’s financial records to look for potential inaccuracies. In addition to direct examination, he or she may gather information through interviews, observation, inquiry, third-party information, and financial analysis.
Misstatements the CPA finds can be the result of either error or fraud. Usually, fraudulent misstatements are more difficult to detect because steps have been taken to cover them, including but not limited to forgery, collusion, or failure to record transactions.
After your business is audited, you’ll receive a formal report that provides the CPA’s independent opinion about whether its financial records are free of material misstatement. He or she will also indicate areas in which internal controls should be strengthened.
Keep in mind that your chances of being audited are relatively low. The Wall Street Journal reported in 2017 that audits had declined for the sixth consecutive year. Americans have about a one in 160 chance of being audited by the IRS, compared to one in 90 odds in 2010.
Although the IRS audits fewer than 1% of tax returns each year, some individual taxpayers will inevitably receive an audit notice. Keep in mind that you will receive an audit notice only in writing through postal mail, not in an email or over the phone. Although you may receive an adjustment notice from the IRS indicating you owe more taxes or are receiving a refund because of an error, this does not mean you are being audited.
If you do receive an audit notice, you should engage the services of a CPA or tax attorney who is certified as an enrolled agent (EA), which means he or she is eligible to represent you before the IRS. If you used tax preparation software to do your taxes yourself, you may be covered by an audit protection guarantee. This could include representation before the IRS or guidance about the correspondence you receive regarding the audit.
When you have a professional lined up to represent you during the audit, sign a power of attorney, so he or she can access the necessary information for the years in question. In most cases, an audit must be completed within three years of the tax filing date, so it’s important to save your tax records for at least that long. In fact, you are legally required to do so. The IRS may go back further if your audit involves understatement of income or fraud. In some cases, electronic documentation may be accepted during an audit.
You may be audited either through correspondence or in person with an IRS representative. In most cases, the process takes at least a few months. You have the right to request a delay while you gather the appropriate documents. Avoid providing tax and financial documents that do not relate directly to the audit.
If you disagree with the results of an audit, you have the right to file an appeal either through the IRS itself or in tax court. Your attorney can advise on which situation is the most advantageous.
Respond to the audit notice as quickly as possible, especially if a minor error or missing paperwork triggered the audit. In this case, provide the documentation requested, which may satisfy the IRS and eliminate the need for a full audit. Do not send documentation that does not directly relate to the audit, however. Remember that in about 80% of cases, the return is simply adjusted and errors corrected. This is known as a correspondence audit and does not require you to appear before the IRS.
When you mail documents to the IRS, make sure to request delivery confirmation from the U.S. Postal Service. This will provide a record that the agency received your paperwork. For correspondence audits, the address where you send your documentation will be included on the audit notice.
The notice will also provide instructions about how to organize your documents. Doing so correctly can expedite the audit process. For example, you should organize documents first by year, then by type of income or expense. Some of the documents the IRS might request as part of an audit include:
If you’ve hired a CPA or tax attorney to represent you before the IRS during audit proceedings, he or she will need all the details of your tax situation. Before your first meeting with this individual, make sure you have gathered:
This will provide your representative with a complete picture of your circumstances for the audit year, which will allow him or her to advocate on your behalf.
Certain red flags on your tax return may increase your risk of an audit. According to Nerd Wallet, these include:
When claiming large deductions, such as if you are affected by a natural disaster, provide as much proof as possible to support your numbers. This should include photos, canceled checks, reports from your insurance company, and repair receipts.
Even if none of these circumstances apply to your tax return, you can still be randomly selected for an audit by the IRS computer system. Receiving an audit notice doesn’t necessarily mean you’ve done anything wrong or that you have cause for concern. High-income households are also more likely to receive an audit notice than lower-income families are. If a business partner or co-investor has been chosen for an audit, you may be required to undergo a related examination.
However, most people who get audited do end up paying additional taxes. In fact, the Tax Foundation reported that the IRS collected an additional $12 billion from audited taxpayers in 2015 alone. You may be able to negotiate with the auditor to make a settlement for this additional amount by paying a lump sum if you can afford to do so. You can also request a payment plan to settle your taxes over time.
In some cases, an IRS audit can result in fines and penalties if you have underpaid your taxes. An erroneous claim that leads to a refund or credit will result in a fine of 20% of the refund or credit amount. If the IRS finds you have filed a frivolous tax return, which means you haven’t provided enough documentation to support the numbers you’ve provided, you could be subject to a penalty of $5,000.
When you disagree with the results of an IRS audit, you have the right to undergo mediation or to file an appeal. Mediation is a confidential but informal process in which an appeals officer who is trained in mediation techniques facilitates an alternative dispute resolution between a taxpayer and the IRS. Although this officer cannot make a decision or force either party to accept a decision, he or she can provide settlement proposals under the Fast Track Settlement Program.
The Fast Track program is available for small-business owners and self-employed individuals. The goal is a resolution of tax disputes within 120 days of initiation. If you disagree with the proposed adjustment after your audit, submit Form 14017, Application for Fast Track Settlement. This does not suspend your right to seek resolution through an appeal or other routes.
When you receive a notice or bill from the IRS that explains your right to an appeal, you can follow the instructions on this correspondence to request an appeal. The appeals system is designed for those who do not agree with an IRS decision and have not signed the form indicating their agreement. If you cannot afford to pay the amount you owe, but you do not have grounds to dispute the amount, you are not eligible for an appeal.
Keep in mind that you have 30 days to appeal from the day you receive the IRS audit decision. You may no longer appeal the decision after 30 days, but you will receive a Statutory Notice of Deficiency at that time. This allows you to petition the U.S. Tax Court if you have a dispute within 90 days. It also includes a statement of your calculated tax liability.
If you agree with this liability, you must sign a waiver to acknowledge the stated amount. The notice will also explain how the adjustment was calculated. The U.S. Tax Court is the only venue in which you can dispute your tax liability without first paying the disputed amount.
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