Inside IRS Audits: The Truth Behind the Process

Key Takeaways

• An IRS audit is an examination of an individual’s or organization’s financial information and accounts to make sure that information is correctly reported, and to verify that the amount of tax reported is correct.

• Correspondence is the most common type of IRS audit, comprising about 75% of all IRS audits, and usually involves a letter seeking more information on part of a return.

• Audits are typically triggered by random computer selection, referrals from other auditors, substantial income changes, or unusually high deductions.

Understanding an Internal Revenue Service (IRS) audit is important for investors who must report taxes and who have investments that might affect their tax liability. However, for many investors and others, there is a degree of mystery about tax audits. 

With that said, here is Inside IRS audits: The truth behind the process. 

What is an IRS Audit?

An Internal Revenue Service audit is an examination of an individual’s or organization’s financial information and accounts to make sure that information is correctly reported, and to verify that the amount of tax reported is correct.

The IRS generally can include in an audit returns filed within the last three years. If the agency spots a significant error, it may add more years. In all, the IRS typically does not go back more than the last six years.

As well-trained tax professionals, auditors are competent at getting anxious taxpayers to provide what they need, even if the information is damaging. Most audits, however, are merely seeking confirmation or clarification of returns.

What are the Types of IRS Audits? 

Many don’t realize that there are various kinds of audits, including:

• Correspondence. This is the most common type of IRS audit, comprising about 75% of all IRS audits. They are also the simplest, usually involving the agency sending a 566-letter requesting more information about a certain part of a tax return. Or the taxpayer will get a CP2000 notice informing them that information provided does not match what was filed with their return.
• Office. This audit requires an in-person visit to an IRS office. It usually occurs when questions about the taxpayer’s return are too large or involved for a correspondence audit. Such audits are usually more detailed and are about business profits/losses, itemized deductions, or rental income/expenses. It is a good idea to get legal advice from a tax lawyer prior to an office audit.
• Field. Of all the audits, this is the most comprehensive. It entails a home or place of business visit from a highly skilled and knowledgeable IRS revenue agent to examine records. If visiting a business, the agent may widen the scope of their visit by interviewing employees, touring a facility, or determining accounting procedures.

What Does the Selection Process Look Like for IRS Audits?

There generally exists a lack of understanding about why the IRS chooses certain returns for audits. To clear up any rumors, here are the top reasons why a taxpayer is audited:

• Random selection. At times, returns are chosen based exclusively on a statistical formula. A taxpayer’s return is sized up against what the IRS calls “norms” for comparable returns. 
• Referrals from other auditors. One’s return may be selected if it involves transactions or issues with, say, business partners or investors, whose tax returns were chosen for audit.
• Substantial income changes. If one’s returns indicated a profit of $400,000 last year, but only $150,000 this year, for example, the government may want to know what happened. 
• Unusually high deductions. Audits can be triggered by deductions that exceed the norm for one’s profession. For example, if individuals in one’s line of work usually spend 17% of their net income on travel, but the return claims 30%, that return may get flagged for review.

Documentation and Record Keeping

There is certain documentation and record-keeping necessary for an IRS audit, which underscores the importance of maintaining all records to substantiate income and deductions claimed.

Such documents will likely include income and bank statements, receipts, and bank statements. The IRS, which does accept tax software-produced electronic records, will send the taxpayer a written request for specific documents it wants to see. Legally, taxpayers must retain all records used to prepare one’s tax return for at least three years from when the return was filed.

What Does the Examination Process Entail?

Depending on the audit type involved, the examination process may require tax return adjustments or additional documentation. An audit notification letter will tell the taxpayer what documentation is needed.

The exam may be conducted via mail or through an in-person records review. If the IRS is notified in advance, the taxpayer may make audio recordings of interviews.

The agency notes that selecting a return for examination does not necessarily suggest that the taxpayer has been dishonest or made a mistake. Some audits result in a taxpayer refund.

How to Prepare Yourself for an Audit

The agency will alert the taxpayer well in advance of their audit date, allowing ample time to diligently gather and organize records.

If a taxpayer is notified of an upcoming audit, there are actions one can take to prepare. Ideally, one has maintained organized, accurate records, so that the process goes as smoothly as possible. Make certain to double-check tax returns and seek professional assistance, if necessary.

Generally, the taxpayer should have documentation for the income, losses, deductions, and expenses claimed on the return. Such records should be organized by year and type (pension plans, income, expenses, and the like). 

Taxpayers should also pull together credit cards and bank records and go through their records to make sure personal and business expenses are separate.

Note that while deliberately minimizing owed taxes through illegal means is tax evasion, the IRS often grants grace if the taxpayer can show that whatever triggered the examination was unintentional.

Tax Considerations in Alternative Investments

Alternative investments – basically any asset classes other than stocks and bonds – can generate passive income streams. Unlike active income, which derives from compensation, tips, and commissions, passive income is earned from interest, dividends, and rental property payments.

Such income is taxable, although sometimes differently than active income. In general, passive income taxation falls under capital gains taxes. The tax rate on this income depends on whether the gain is deemed short- or long-term.

In addition to directly investing in businesses, investors can also take advantage of private investment opportunities such as those offered by the leading alternative investment platform Yieldstreet. Such investments cover a wide range of asset classes, including art and real estate.

They also serve to diversify investment portfolios, which is essential to long-term successful investing. Spreading varying asset classes across one’s investment portfolio can mitigate overall portfolio risk and volatility, and even protect against inflation. 

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

It is essential for investors to understand IRS audits and what to do if it happens to them. It is also important to keep in mind tax considerations in alternative investments, which are increasingly popular as investors seek to reduce portfolio risk and volatility.