What to Do When the IRS Audits You
Photo by Kelly Sikkema on Unsplash
The IRS has been dropping a new press release with an explicit threat to the bank accounts of successful Americans every other month or so. Their messaging sounds increasingly political, and high-income taxpayers would be foolish to ignore what they’re saying: the IRS plans more audits of successful Americans to force them to pay more taxes.
When a hurricane is coming, you board up the windows and stock up on bottled water. When the IRS is planning a storm of audits of people who look just like you, you need an audit response plan.
The IRS and the Biden administration keep repeating they’re targeting “the wealthiest Americans,” with incomes of $400,000 or more, but actual audit data say that right now, 63% of all new audits are focused on taxpayers with less than $200,000 of income. So maybe more than just the “wealthiest Americans” ought to be thinking this audit response planning, too.
So, considering those preparations, the first principle is this: don’t cower in fear. Know your opponent, anticipate their actions, and plan a response. In this situation, the IRS is your opponent. Knowledge about its agents and their process is power for you.
The IRS has a revenue maximization strategy in place — it’s been very public about it — and it wants cowed taxpayers to knuckle under and “pay their fair share.” It wants to “close loopholes” when the fact is, legal loopholes are created in the tax laws, and tax laws are the province solely of the U.S. Congress.
The IRS likes to audit people it thinks it can get serious money from. Data from my own practice, serving mostly higher-income taxpayers, suggest that audit rates have been under one percent. They’re going to rise.
Let’s strip away the mystery of the IRS audit itself and examine the best way to respond to one.
When the IRS’s algorithm flags your return for audit — and that algorithm is a highly guarded secret, to keep taxpayers on their toes — you’ll get an Audit Notice. Audit Notices can demand taxpayer documentation for items on their tax returns or require an in-person (or remote) meeting with IRS auditors.
An individual auditor will be assigned to your case. The IRS sets a response deadline, which you’ll want to meet if at all possible to avoid having a meeting date and location set unilaterally by the IRS.
My experience says that audit triggers include business income calculations of all kinds; math errors; unusual sources of income (foreign or gambling income, large volumes of cash transactions); and, unfortunately, high-profile public stances against the IRS and our tax system in general by the taxpayer. (The IRS says it would never do that. My observations say the opposite.)
If it’s a “records audit,” you’ll be asked to provide documents by mail or fax (!). If it’s an in-person audit, your auditor will track you down to schedule a meeting — usually in the nearest IRS office.
I don’t like my clients to attend a meeting with the IRS. Full stop. Taxpayers can give a qualified, credentialed representative (generally an accountant or lawyer or someone who’s both) their power of attorney, and that representative can then stand in for them at any audit meeting.
This is why: if you’ve ever been sued and deposed, or you had a brush with law enforcement as a teenager, you know that certain questions don’t seem logical or aren’t following a predictable path. You’re being interrogated. You don’t want an innocent answer of your own to unwittingly open a whole can of worms that can lead your case down a long and expensive trail.
The IRS doesn’t love you having a representative standing in for you — and that should be enough to make you certain to have one.
I don’t take much to an IRS audit meeting on behalf of a client. I’ll take the documents that respond to the IRS’s requests. I’ll take a copy of the client’s tax return. And that’s it.
The IRS auditor often is not at all familiar with the client’s tax return. The auditor may not even have a full copy of the return — he often asks me for one.
Because I bring no extra records to look at, fishing expeditions are stopped before the boat even leaves the dock. We usually engage in some quick small talk and introductions, and I let him know I’m on the clock for the customer, and I’d like to get to the bottom of the audit request.
With good preparation, these meetings are usually bang-bang-bang, and over in 30 minutes or so. The auditor then reviews the documentation and answers. He can propose adjustments or request additional information within a few weeks. Your professional is your financial and privacy bodyguard and will push back on your behalf when the IRS tries to overstep its bounds (and it will).
Eventually, you’ll get a proposed settlement document from the IRS. Your adviser can efficiently cut through the fog to advise you whether to accept the IRS’s proposed settlement or to man the battle stations.
If you don’t like the audit outcome, there are two routes for appeal: a compliance appeal and tax court. Tax court leaves more running room if an initial decision is unfavorable to you, but it costs a bit more to pursue relief.
The costs of the audit response are fairly straightforward. Simple ones typically cost $1,500–2,000 in professional time. More complex ones cost more. Appeals, depending on the complexity, can cost significantly more. When hundreds of thousands of dollars or more of taxes hang in the balance, it can be worth it.
I’m in the business of tax strategy, preparation, and representation, so you can take this with a grain of salt, but I believe that anyone running a successful business, or who is a highly compensated employee, is a fool to prepare his own taxes.
Why? Because the defense of an audit doesn’t begin when an audit notice arrives. Professionals help build the ramparts of your audit defense during the preparation of your return.
To sum up, these are my simple recommendations for well off Americans facing down a hostile and ideological IRS:
1. Don’t do things you obviously shouldn’t do on your tax return. Don’t call a family vacation with one day of seminar attendance a business expense. Don’t play games with salary or compensation — your own or family members’ — unless you fully vet what you’re doing with a tax professional. It’s easier to respond to an audit when the IRS’s one question isn’t a gateway to a dozen things you shouldn’t have done. Your judgment is a lot clearer when you’re not nervous about getting caught for something else. Use legal tax minimization strategies, of which there are plenty.
2. Records win. Document, document, document. If you don’t have good documentation, you’re going to have a very hard time winning an audit.
3. Don’t be penny-wise and pound-foolish. Even if you do choose to do your own taxes — if you get audited, do not attempt to fly solo. You are not your own best advocate. Let someone else do the heavy lifting and position you for optimal outcomes. It’ll pay for itself several times over.
Successful taxpayers are unquestionably in the IRS’s financial gun sights right now. You’re well advised to prepare for the coming fusillade.