What Happens During an IRS Audit?

Audits aren't a moral judgment. Nor does an audit notification mean the IRS thinks you're an outlaw or tax cheat. An IRS audit, often called an "examination," is basically just a review of your records to ensure information recorded on your tax return has been reported correctly and in accordance with tax law.

So, if your records are in good shape, and you work with the agent in a professional and friendly manner, you may be able to resolve whatever issue may have caught the IRS's attention without too much effort. That said, audits can become more onerous and intrusive if your books are in disarray, or you choose not to cooperate.

There are basically three types of IRS audit: correspondence audits, office audits, and field audits.

As the name implies, correspondence audits occur entirely by mail. 

The simplest form of IRS correspondence isn't technically an audit at all. If the IRS spots a mistake in your return—say, if you fail to report some income or get a calculation wrong—the agency will send you a letter letting you know and asking you to pay any extra taxes by a specified date. In such cases, you can either pay the bill (plus any interest or penalties) or let the IRS know if you think they've made a mistake of their own. Of course, you'll need to provide proof. 

In a full audit, you'll receive an information document request, or IDR. This letter will request detailed financial records to back up certain amounts being examined on your tax return. For example, if you claimed an expense for your business, the IRS might ask for specific receipts, bills, and proof of payment. Be sure to provide the requested information within the deadline, as well as a written explanation of how it supports your case.

Office audits entail you visiting an IRS office to go over your records in person. But first you will receive an IDR specifying which records you should bring with you.

Office audits can go quickly if your records are clear. It's not a good idea to show up with a big box of papers or receipts that you'll need to sort through. Keep it orderly. In general, the quicker the agent can match transactions to receipts or bank records, the sooner you can get out of there.

These are the most extensive kind of audit, as they involve agents coming to your home or business to go through your records. Beforehand, you will get a longer IDR, so you'll be able to prepare whatever documents the IRS wants to see. That said, the agent may not limit their review to just those items. If they see any large, unusual, or questionable items, the audit could be expanded.

Either way, it's in your interest to have your records—receipts, bank records, etc.—in order and reconciled to your return. If the agent come to your business, they'll likely ask for your general ledger, balance sheet, and income statement. Then, they'll look at samples of transactions to make sure everything lines up with your filing.

Unless your business is a large corporation, you'll likely be dealing with only one agent. You can assume they've done their homework on your finances before the audit. In fact, they may ask questions to which they already know the answers, just to make sure you're being open and honest.

It doesn't have to be an adversarial situation. The agent isn't coming in to look at everything, and if the material they do look at checks out, they'll likely move on. However, if you aren't forthcoming and your documentation ends up differing from what's on the return, they're likely to dig more. Keep in mind, if you work with the agent in a professional and friendly manner, you can boost the odds of the audit going smoothly and quickly.

Once the audit portion is done, the IRS will issue a report laying out the findings. It's worth noting that audits don't automatically mean more taxes. The IRS may decide no changes are warranted, or you could even end up with a refund.

Whatever the outcome, you can either agree or appeal those findings. Appeals are heard by an independent body within the IRS that exists to resolve disputes between the IRS and taxpayers, sort of like an arbitration panel. And if you end up disagreeing with the appeals decision, you can also take your case to court.

So, what can you do if you find out you're being audited? Here are some tips:

• Get your documents in order. We covered this a couple times already, but it bears repeating. If your paperwork is orderly—with all your financial statements, bank records, and receipts in order and easy to map out—it tends to make the whole process that much smoother. If you're called in for an office visit or are subject to a field audit, consider gathering the requested documents into binders and show the agent that your books match the tax return. This can help tell a simple story: That you're organized, not hiding anything, and have done your due diligence in preparing your taxes.
• Audit yourself. Audits tend to happen at least a year or two after you filed your return, which means you may not remember everything that occurred clearly. Make use of those carefully organized records by doing a trial run on yourself. Test your deductions by producing all the necessary receipts or bills. If you're a business owner, take samples from your general ledger and match them with checks or receipts. This will help you remember what occurred in the past and boost your confidence ahead of the actual audit. And if you find something that doesn't look right, let the agent know in advance. It'll create trust.
• Be forthcoming. As suggested above, refusing to produce paperwork or being evasive when answering questions could just invite more aggressive digging. If you don't remember details about a particular transaction, you should say so. Don't be tempted to make things up on the fly.
• Bring in a professional representative. The most effective representatives tend to be those who have experience with IRS audits. A good place to start is to look for a person with a certification such as Certified Public Accountant (CPA), Enrolled Agent (EA), or tax attorney. Having a tax professional on hand can help clarify technical points and avoid confusion. For example, I remember one audit in which a small business owner accidentally referred to a "contractor" as an "employee"—which could have triggered some employment tax issues. Fortunately, his CPA jumped in and corrected the owner, clarifying that the worker was a contract worker. 

Though an audit is never fun, it's not the end of the world, and you can do a lot to help make the process less painful. Being organized and open can help you get through it more quickly. Yes, you may end up having to pay more in taxes if the IRS disagrees with your interpretation of the evidence, but getting there doesn't have to be a battle.