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IRS Audit Penalties

The IRS is responsible for processing the annual tax returns of every adult taxpayer and business. If the IRS finds any discrepancies while processing a return, the IRS might want to take a closer look. This review process is known as an audit, and the IRS conducts hundreds of thousands of them every year. Depending on what the audit discovers, there can be severe penalties and consequences. 

If you have received a notice from the IRS informing you about a potential audit, you should take immediate action. The first thing that you should do is consult with a tax professional as going at it alone can be risky. Like the ones at Coast One Tax Group, tax experts can review your financial information and guide you through the audit process. 

How Often Are Audits Conducted?

The odds of being audited are probably much lower than you think. The total number of audits has fallen fairly dramatically in the last decade. In 2010, the IRS conducted more than 1.5 million audits. However, there were less than 510,000 audits completed in 2020.

 Although the odds of being audited are much lower, you should still follow the rules and guidelines for filing your taxes. The 510,000 audits led to an additional $12.9 billion in taxes being collected, so the penalties can be very steep. 

What Triggers an Audit?

The IRS will have to process hundreds of millions of tax returns filed by individual taxpayers and businesses every year. There isn’t enough time for the IRS to thoroughly review and examine every return by hand, so they created a Discriminant Information Function computer program (DIF computer system). 

The DIF scans every tax return that the IRS receives and looks for any errors, discrepancies, or bizarre behavior. If the DIF finds anything abnormal, it will flag the return, and an IRS agent will review it. They will then determine whether or not they should launch an audit. 

These are a few of the most common issues that trigger an audit:

Mathematical Errors

One of the most common reasons a return will be flagged is simple mathematical errors. Accidentally adding an extra zero or mistyping a few numbers can dramatically throw off your totals. 

Even if the errors are completely accidental, the IRS can still hit you with penalties, late fees, and other charges. Take the time and make sure to double and triple-check your return for any mathematical errors before you file.  

Underreported Income

The less money you make, the less money you will have to pay in taxes. Some people will try to cheat the IRS by reporting that they made less money during the year than they did. The problem with this plan is the IRS probably knows exactly how much money you made. 

Whether it’s by a W-2 or 1099 form, your employer will issue you with a financial statement of your earnings throughout the year. They are also required to submit a copy to the IRS. If your tax return lists different financial information than what’s on file at the IRS, it could trigger an audit. 

Too Many Charitable Donations

Tax deductions are meant to help people in need by providing them with a way to pay fewer taxes and save money. However, if you are claiming a significant amount of deductions, the DIF would raise a few red flags. 

Giving away a few hundred dollars a year in charitable donations makes sense for most people. But giving away $35,000 on a $50,000 salary would look very suspicious. 

Misusing the Home Office Deduction

Another common deduction that can get people into trouble is the home-based deduction. The number of people working from home has increased sharply in the last few years, and more people are using this deduction than before. The problem is that there are a lot of misunderstandings about how these deductions work

One area where taxpayers can slip up is that you cannot use the home office area for anything other than business. Simply working from home does not qualify you to use the home office deduction. 

How Do You Know You’re Being Audited?

First, at the beginning of the audit, the IRS will send you a notice in the mail. Be wary of any phone calls or emails that claim to be coming from the IRS, as they are likely scams. The tax notice will give you information about what is happening and instructions on proceeding. Most IRS audits will take place by mail, but the IRS may request an in-person audit. 

After receiving this notice of an impending audit, you should consider talking with a tax lawyer. You can quickly incriminate yourself during an audit if you aren’t careful and might end up in pretty serious trouble. A tax professional can review your financial situation and safely guide you through the process of an audit. 

How Long Does an Audit Take?

An IRS audit will take as long as necessary. The IRS is under no obligation to wrap up its audit until they have thoroughly reviewed every piece of relevant information. That said, most audits are usually completed between three to six months after being launched. 

It largely depends on how cooperative you are with the IRS, how accurate and organized your records are, and the severity of the audit. If you disagree with the audit’s conclusions, the IRS will extend the process by a few months to include the appeal.

What Information Does the IRS Need During an Audit?

There are plenty of different things that might have triggered the audit. Depending on the nature of the issue that flagged your account, the IRS might require different documents. It’s best to keep highly detailed and organized financial records just in case of an audit. 

These are a few of the financial documents that the IRS might request during an audit:

  • Receipts
  • Invoices
  • Bills
  • Expenses
  • Deductions or credits
  • Canceled checks
  • Legal papers
  • Loan agreements
  • Logs or diaries
  • Employment documents
  • Tickets
  • Medical and dental records

What Are the Possible Penalties of Being Audited?

Depending on the audit results, you could end up getting into very hot water with the IRS. The most common type of penalty used by the IRS is financial, but the IRS auditor can suggest criminal charges in some cases. 

There are essentially four different types of penalties that might come from being audited:

Interest Charges

The IRS normally tacks on interest to any amount of money you owe. There is no flat interest rate, and it will largely depend on how long past due the payments are and how much you owe. 

The interest charges are often backloaded onto your tax obligation. If an audit determines that you owed additional unpaid taxes on your return, you would be charged interest for each month after Tax Day along with late fees. 

Civil Penalty

A civil penalty may be issued if you have a substantial difference between your listed tax obligation and what the IRS claims that you owe. The penalty can range between 20% and 40% of the underpaid amount. The IRS will add the total amount to the remaining difference in taxes you already owe. 

The IRS may bump this penalty up to 75% in extreme fraud cases. This severe punishment is usually reserved for individuals attempting to engage in felony tax evasion.

Asset Forfeiture

The IRS is legally permitted to seize your assets if you have a significant amount of tax owed. Your house, vehicle, and land can all be legally forfeited and taken by the IRS. They will then sell these items and apply the proceeds to your outstanding back taxes. 

The IRS is also legally allowed to garnish your wages, 401(k), and even bank accounts to reclaim the tax amount that you owe. There is very little that you own that the IRS can’t legally seize if they’ve determined you owe them. 

Criminal Penalty

These consequences usually come with criminal charges for tax evasion and fraud. Intentionally failing to file a tax return, filing a fraudulent return, or willfully misrepresenting your finances are all federal crimes. 

Failing to file can result in a $25,000 fine every year that you don’t file, along with a year in prison. Filing a fraudulent return can result in a $100,000 fine and up to three years in prison. Misrepresenting your finances constitutes tax evasion, resulting in a $250,000 fine and up to five years in prison.   

The Takeaway

The IRS is a very powerful federal agency and has the full support of the United States government behind it. Whether on purpose or by accident, paying fewer taxes than you owe can trigger an audit. The IRS will thoroughly review and examine your financial information and determine your tax obligation. 

There can be severe penalties depending on the difference between what you paid and what you owe. Most people will simply incur a few interest penalties and late fees. However, you might end up owing tens of thousands of dollars and serving time in prison. 

If you’ve received a notice from the IRS that you’re being audited, you should immediately take action. Talk with the tax resolution professionals at Coast One Tax Group about what you should do during the audit process. They can advise you on how to proceed and keep you from getting into serious trouble. 

SOURCES:

IRS audit rates significantly increase as income rises | Internal Revenue Service

Top Audit Triggers That Catch the Attention of the IRS | The Balance

IRS Audits | Internal Revenue Service

IRS audits fell in 2020 — with one big exception | MarketWatch

Publication 587 (2020), Business Use of Your Home | Internal Revenue Service

IRS Tax Audit Facts | Money

Topic No. 654 Understanding Your CP75 or CP75A Notice Request for Supporting Documentation | Internal Revenue Service