The idea of a tax audit often evokes images of an office in disarray as IRS agents pore over records looking for inconsistencies. In reality, most IRS audits are simply a letter in the mail requesting documentation of anomalous line items. Problems occur when you cannot furnish the documentation or make mistakes that trigger penalties and interest.
Let’s take a closer look at tax audits and what puts you at risk for them, as well as two strategies that you can use to reduce your risk.
What is a Tax Audit?
A tax audit is simply when the IRS examines your tax return a little more closely to verify that your income and deductions are accurate. Oftentimes, tax returns are selected for an audit when something appears out of the ordinary.
Sample IRS Audit Letters - Source: Tax Audit
There are three types of audits:
- Mail Audits: The IRS will send you a letter requesting additional documentation. For example, if you claimed a charitable deduction, the IRS may want to see receipts.
- Office Audits: The IRS may request an in-person meeting at a local IRS office where you will be questioned by an IRS officer about your tax return.
- Field Audits: The IRS will visit your home or office to discuss your tax return in-depth, often line by line, to ensure that it’s accurate.
Tax audits may have several different outcomes. In many cases, the IRS may be satisfied with your explanation or documentation and have no further requests. In other cases, they may identify a mistake that you made and agree to fix.
If you agree with an IRS audit assessment, you will typically sign an examination report or other form and arrange to make a payment. If you disagree, you can request a meeting with an IRS manager or request a formal appeals conference.
What Are the Risk Factors?
The good news is that the absolute risk of a tax audit is very low. For example, the IRS audited just 0.4% of all individual tax returns in 2019, and that was down from about 0.6% in 2018. That said, there are some risk factors that can increase your relative risk quite a bit.
Some of the most common risk factors include:
- Virtual Currencies: The IRS has been cracking down on individuals that failed to pay tax on crypto transactions. If you trade crypto, you should always report it to the IRS to avoid the risk of an audit down the road.
- Missing Income: The IRS receives copies of all W2s and 1099s and they’re good at matching those numbers with your reported income. Any mismatch between the numbers creates a red flag that increases the odds of an audit.
- High Income: Individuals with incomes of $200,000 to $1 million have a 1-in-100 chance of being audited and that risk goes up to 1-in-40 for those with incomes over $1 million.
- Credits & Deductions: Excessive deductions or credits can increase the risk of an audit. In particular, large write-offs for meals, travel and entertainment expenses or 100% business use vehicles for self-employed individuals are common red flags.
- Business Owners: Schedule C enables individuals to take a lot of deductions, but the IRS typically takes a close look if you report over $100,000 in gross receipts. In particular, the IRS looks for those claiming hobby losses as business losses.
These are just a few of the risk factors that could lead to an IRS audit. While many of these red flags are unavoidable, such as being a business owner or making more than $1 million per year in income, you can take steps to mitigate risk and ensure that you have all of the documentation that you need in place in case there’s an audit.
How to Shorten the Clock
The IRS can only audit your tax returns back to a certain date, known as the statute of limitations. For example, if you made a mistake five years ago on a tax return, the IRS may not be able to audit you even if they do discover the mistake.
The default statute of limitations is three years, but if you underreport income by more than 25 percent, the statute of limitations jumps to six years. If you do not file a tax return or commit fraud (e.g. knowingly make omissions), you can be audited at any time.
You can shorten the statute of limitations by filing tax returns as soon as possible to start the audit clock. Of course, you should never fail to file a tax return (or knowingly commit fraud) since that opens the door for the IRS to audit you at any time without limitation.
Always Be Prepared for an Audit
IRS tax audits are a numbers game and unavoidable to some extent. Fortunately, most audits are simple mail requests for more documentation. Assuming that you didn’t make a mistake, you simply need to furnish the right documentation to make your case. The problem is that most people don’t keep good records and the process becomes time-consuming.
For crypto traders and investors, the record keeping process is complicated by the nature of crypto transactions. The capital gain or loss from crypto-to-crypto trades must be reconciled in U.S. dollars while ICOs, airdrops and other transactions introduce even more complexity.
ZenLedger’s Platform - Source: ZenLedger
The best way to keep clean crypto records is using tax software. ZenLedger connects with crypto exchanges and wallets, aggregates transactions across them and automatically calculates your capital gains or losses. The platform even pre-fills popular IRS forms and identifies opportunities to harvest tax losses throughout the year.
If you’re audited, ZenLedger makes it easy to pull a complete transaction record that transparently justifies the capital gain and loss calculations. You don’t have to worry about spending a ton of billable hours with your accountant to pore over crypto transactions and can sleep easy knowing that you have accurately filed your return.
The Bottom Line
The idea of an IRS audit may seem scary and uncertain, but with the right processes in place, you can minimize your risk and prepare in advance. While most people are unlikely to be audited, you should always be prepared for an audit by keeping records and using the right tools to ensure transparent and accurate calculations.