A tax audit is performed to determine the accuracy of federal or state tax returns. An audit notice can cause anxiety for your client and will require time and effort to resolve.
You can minimize the impact of an audit by staying up-to-date on tax law changes, communicating effectively with your client, and gathering supporting documents.
Different regulators conduct state and federal tax audits. In addition, state tax authorities may focus on different tax compliance issues than the Internal Revenue Service (IRS).
The IRS conducts audits based on federal law, and the agency may audit federal income tax, payroll tax, gift tax, or estate tax returns.
State tax audits are initiated by the state’s Department of Revenue or another state agency that manages tax collections. States perform audits on state income tax, sales tax, excise tax, and other revenue sources based on state law.
Inconsistent reporting can trigger a tax audit at the federal or state level. Here are some examples:
Large changes in income or expenses from one year to the next can also trigger an audit.
The IRS and state taxing authorities share tax data. A federal tax audit may also trigger a state tax audit. If the IRS learns of a state audit, they may start a federal audit.
On the other hand, it’s possible that an input error only affects the federal return and not the state return (or vice versa).
Sales tax complexity can lead to mistakes, which can trigger an audit.
Forty-five states currently have state sales tax, and tracking state sales tax rates and rules can be challenging for businesses. For example, the frequency of tax reporting may depend on the dollar amount of sales tax collected, and tax reporting differs by state.
States audit other types of income, but sales tax audits are common.
Here are some situations that may trigger an IRS audit:
Tax law allows self-employed taxpayers to take the home office deduction. Determining the correct deduction amount may be complicated, and errors can trigger an audit.
A large decrease in income from prior years may be a red flag for the IRS. If a taxpayer’s W-2 income drops 30% from the prior year and the employee works for the same company, the income decline may draw attention.
The IRS defines a hobby as an activity that a person pursues because they enjoy it and with no intention of making a profit. If a business generates a loss for several consecutive years, the IRS may classify the activity as a hobby.
As you prepare client tax returns, pay attention to situations that increase the risk of an audit.
The type of audit has an impact on the amount of time required to assist your tax client.
In this case, the tax authority requests supporting documentation by mail. The taxpayer provides documents to support business deductions or tax credits on the tax return. Correspondence audits can be resolved with proper documentation.
These audits are conducted at an IRS or state tax agency office. The taxpayer provides documentation and may be asked more detailed questions about transactions.
The tax preparer or a tax attorney may attend the meeting.
Field audits are conducted at the taxpayer’s home or business location. The auditors examine books and records used to produce the tax return.
This is the most comprehensive and time-consuming type of audit.
States may audit franchise tax returns and sales tax returns, as well as state income tax filings.
If a client is notified of an audit, get a clear understanding of the type of audit required. This step helps you prepare for the process and answer the client’s questions.
As a tax preparer, your goal is to resolve the tax audit issues as quickly and smoothly as possible. Reduce your client’s anxiety by clearly communicating the audit process and the records needed to address each tax issue.
An attorney, CPA, or enrolled agent can represent the taxpayer during an IRS audit. If you meet the requirement, discuss representation with your client and determine how they want to manage the audit process.
If the issues are complex and you have limited experience with the topics under audit, consider bringing in an expert to provide guidance. Follow the IRS or state tax rules regarding this situation.
If a state requests an audit, review the state’s tax laws regarding representation.
Carefully review the notice from the IRS or state tax agency and note the deadline for responding. Ensure that the response is sent before the deadline to avoid penalties.
Note the specific income, deduction, or other issues that are under audit.
Gather the necessary documentation and organize the data to minimize the auditor’s review time.
Records for an individual return may include bank statements, 1099s, W-2s, and K-1s. For business audits, the auditor may require payroll records, the general ledger, and documents related to purchases and sales.
You may need to provide documentation, written explanations, and answer auditor questions to resolve the audit. Only provide information that directly addresses the audit issue.
If the audit report recommends adjustments that result in additional taxes owed or penalties, review the proposed changes with the client. Advise the client on whether the adjustments should be accepted or if the audit should be appealed.
A tax audit is stressful for taxpayers, and the time-consuming process reduces the hours you can spend on other client issues. Reduce the chances of an audit by paying attention to these specific areas of risk.
Check the prior year tax return and determine if each source of income applies to the current year. Ensure that the amount reported on W-2s, 1099s, and K-1s matches the data on each form.
You can reduce error rates by using tax software that inputs income data directly into the tax return.
A large change in income is likely to get the attention of an auditor. Have explanations prepared before you file the return.
An individual may inherit assets, take a retirement distribution, sell a home, or incur large medical expenses. A business may buy or sell assets or purchase a competitor to increase total revenue.
All of these situations may cause a change in income.
Refer to the IRS publications that determine if an activity should be classified as a hobby.
It’s not unusual for a business (particularly a new company) to generate losses in consecutive years. Clients should keep business plans, marketing and sales efforts, and other documents to confirm intent to earn a profit.
Advise clients to maintain detailed files to prove that all deductions are legitimate. Help the client to comply with current tax code requirements for each deduction.
Follow guidelines to determine if an asset should be listed at book value, market value, or another valuation method. If a high-value asset does not trade in a market that provides liquidity, consider getting an appraisal for the asset.
Sigma Tax Pro’s professional tax software helps tax professionals avoid audit triggers through comprehensive error checking, accurate calculations, and proper documentation management.When audits do occur, Sigma’s Audit Assistance Program handles all IRS correspondence for denied credits and schedules, offering you a revenue opportunity while ensuring clients get their deserved refunds.
Reach out to Sigma Tax Pro today to learn more.
