The ranks of IRS auditors are growing — fast. More than 2,500 new auditors will be (or have already been) hired, and increased audit activity will surely follow. The last couple of years have brought a flurry of new IRS practices and pandemic tax changes that might have even the most confident filer uneasy about the possibility of being selected for an audit.
The Odds of Being Audited
During the past decade, the number of IRS audits has dropped dramatically. The latest IRS Data Book (https://www.irs.gov/pub/irs-prior/p55b–2020.pdf) reports the agency audited nearly 1.6 million 2010 tax returns but fewer than 400,000 for the 2018 tax year (the most recent year for which it offers comparisons).
As a result, the odds of your business being audited have dropped significantly. In 2010, about one in 64 C corporation returns was selected for audit; by 2018, that rate was down to one in 350. S corporations and partnerships saw comparable trends. Although the coming boost in IRS audit resources is expected to reverse that trend, most companies’ odds of being audited will remain low.
How the IRS Chooses Audit Targets
Although the majority of the 2018 audits involved individual tax returns, many of those exams were follow-up letters involving suspected errors in claiming the Earned Income Tax Credit (EITC). The agency’s National Research Program estimates that about half of all EITC claims contain errors.
Setting aside that anomaly, the odds of an individual return being audited are directly related to the taxpayer’s income. For a taxpayer with adjusted gross income (AGI) above $10 million, the odds of being audited are one in 20. For taxpayers with AGIs between $5 million and $10 million, the odds drop to one in 100. And for taxpayers reporting AGIs between $75,000 and $100,000, the odds are one in 1,000.
Business returns show a similar pattern. For 2018, about 37 percent of C corporations reporting more than $20 billion in assets were audited; for corporations with less than $10 million in assets, the audit rate was about 2 percent.
Beyond its logical focus on larger businesses, the IRS uses other methods to decide which returns to audit. Often returns are selected based on statistical formulas that compare them against a random sample of similar returns. Unusual expenses, credits, or other figures that are outside the norm could trigger an audit.
In addition, the IRS often selects returns that are related to other returns it is already auditing. For example, if one business partner is selected for an audit, it increases the chances that other partners will be audited as well.
What to Expect in an Audit
For individual taxpayers, most audits the IRS closed during fiscal year 2020 were “correspondence audits”—written inquiries or examinations that were handled by mail. That’s not the case for business returns, however. The majority of C corporation, S corporation, and partnership audits completed in 2020 were in-person “field audits.”
If your business is selected for an audit, here are some points to remember:
1) Don’t be scammed. If you receive a telephone call informing you that the IRS has initiated an audit, just hang up. The IRS never initiates an audit by phone. Once an audit is underway, there might be follow-up calls, but the initial notice always arrives via the Postal Service.
2) Call your CPA immediately. From the moment you receive an audit notice, you should send your CPA complete copies of everything you receive and let him or her handle all communications. Do not respond on your own.
3) Understand what’s in store. Field audit procedures have changed significantly in response to COVID-19. After closing almost all field offices at the beginning of the pandemic, the IRS began reopening some offices later in 2020. Nevertheless, most meetings with IRS agents are now handled virtually.
4) “Keep calm and carry on.” Being selected for an audit does not necessarily mean there’s a problem. If an in-person or virtual meeting is required, follow your accountant’s lead. Keep things professional, provide the requested documentation, and answer questions honestly—but don’t volunteer information that isn’t called for.
5) Trust the process. It’s not uncommon for the audit to take more than six months due to all the information that must be collected, checked, and double-checked. Just because your accountant requests an extension doesn’t mean you should be pessimistic.
Your relationship with your CPA is a collaborative one, and it never hurts to familiarize yourself with your rights as a taxpayer and the audit process. IRS Publication 1 is a good place to start: https://www.irs.gov/pub/irs-pdf/p1.pdf
Audits happen. The tax code changes. Your financial position can shift unexpectedly. A trusted relationship with a tax advisor can help you successfully navigate these challenges, and It’s never too early or too late to start one. Contact Dembo Jones today.