How An Audit Works

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How a Tax Return Audit Works

Sometimes we all shake our heads in disbelief over what might happen in an IRS tax return audit. However, we always have to keep in mind that the IRS has guidelines it gives all its tax return auditors to follow when conducting federal tax return audits. Armed with this knowledge of the Internal Revenue Manual, we can compare what a single auditor might be trying to do with your case and we can compare that to what the IRM says is allowable. If he or she is overstepping, we can alert the auditor and demand that they cease their behavior. So you can see that we work on our client’s behalf to ensure that the tax return audit follows the rules.

Next, as the IRS uses the word, IRS auditing includes the accumulation of evidence for evaluating the accuracy of the taxpayer’s tax return(s). Evidence takes many forms, including the taxpayer’s testimony (read ‘affidavit’), the taxpayer’s books and records, the examiner’s own observations and documents from third parties.

The IRS instructs its tax audit representatives that their job is to gather together enough documentation and testimony to find out whether your tax return is accurate, complete, not fraudulent. Every examiner must determine the sufficiency of records to decide the proper depth of the examination. Deciding how to far to dig is something the IRS puts great emphasis on. This is cost of examining and evaluating evidence can quickly become prohibitive if the audit goes too far afield. According to the Internal Revenue Manual, the factors to consider when establishing the depth of the examination include:

A. The risk that the taxpayer has made errors that are individually or collectively meaningful. The factors involved are addressed during the evaluation of the taxpayer’s internal controls.

B. The risk that the audit tests will fail to uncover material errors. The factors involved are the depth of the examination, the examination techniques used, the nature of the errors (intentional or unintentional) and the reliability of available evidence.

IRS audit guidelines also list methods for accumulating evidence include:

A. Analytical Tests – such as analysis of Balance Sheet items to identify large, unusual, or questionable accounts. Analytical tests use comparisons and relationships to isolate accounts and transactions that should be further examined or determine that further inquiry or extension of the tax audit is not needed.
B. Documentation – such as examining the taxpayer’s books and records to determine the content, accuracy, and substantiate items claimed on the tax return.
C. Inquiry – such as interviewing the taxpayer or third parties. Information from independent third parties can confirm or verify the accuracy of information presented by the taxpayer.
D. Inspection – such as physically examining the taxpayer’s assets, e.g., inventory or securities.
E. Observation – such as conducting a tour of the taxpayer’s business to observe the taxpayer’s daily business operations.
F. Testing – such as tracing transactions to determine if they are correctly recorded and summarized in the taxpayer’s books and records.

Finally, how an IRS tax audit will be approached is the subject of several factors to consider when choosing an examination technique. These factors are:

A. Will the examination technique provide the needed evidence?
B. Will the benefits derived from using a particular technique justify the associated costs to both the examiner and the taxpayer?
C. Are there less expensive alternatives that will provide the same evidence?
IRS audit guidelines for a tax return audit give the auditor many ways to investigate a taxpayer’s federal tax return, including:
A. Interviews
B. Tours of Business Sites and Inspection of Residences
C. Evaluation of the Taxpayer’s Internal Controls
D. Examining the Taxpayer’s Books and Records
E. Analyzing Schedules 1 and M2
F. Bank Record Reconciliations
G. Balance Sheet Analyses
H. Testing Gross Receipts or Sales
I. Testing Expenses: Cost of Goods Sold
J. Testing Expenses: Operating Expenses
K. Sampling Techniques

You will find that in most IRS audits a combination of these choices are used, and oftentimes they will all be used in a particular audit where, at the start, the taxpayer is found to have perhaps under-reported income and claimed deductions that he cannot substantiate.