The Internal Revenue Service (IRS) plays a crucial role in administering and enforcing federal tax laws. One of its primary functions is to examine tax returns to ensure accuracy and compliance. This examination process is known as an audit. Additionally, the IRS has the authority to impose penalties on taxpayers who fail to comply with tax laws. Understanding the IRS audit procedure and the various penalties that can be assessed is essential for all taxpayers.

IRS Audit

An IRS audit is a review or examination of a taxpayer’s return or financial information to ensure that income, deductions, and credits are reported accurately and that the correct amount of tax is paid. Audits can be initiated for various reasons and can take different forms.

The IRS uses various methods to select tax returns for audit:

• Random Selection and Computer Screening: Some returns are selected randomly as part of a statistical sample to help the IRS monitor compliance trends. The IRS also uses computer programs to identify returns with a high probability of errors or discrepancies based on certain criteria and historical data.
• Information Matching: The IRS compares the information reported on a taxpayer’s return with information it receives from third parties, such as employers (Form W-2), banks (Form 1099-INT), and brokerage firms (Form 1099-DIV). Discrepancies between these sources can trigger an audit.
• Related Examinations: If the IRS is auditing the return of a business partner, investor, or other related party, it may also decide to audit the taxpayer’s return. 

• Correspondence Audit: This is the most common type of audit and is conducted entirely through the mail. The IRS will send a letter to the taxpayer requesting specific information or documentation to support certain items on their tax return. This type of audit is usually focused on a few specific issues. 
• Office Audit: In an office audit, the taxpayer is required to meet with an IRS auditor at an IRS office. The IRS will notify the taxpayer by mail about the date, time, and location of the audit, as well as the specific items on the tax return that will be reviewed. Office audits are typically more complex than correspondence audits and may involve a broader range of issues.  
• Field Audit: A field audit is the least common type and involves an IRS auditor visiting the taxpayer’s home, place of business, or accountant’s office. These audits are usually the most complex and often involve businesses or high-income individuals. 

The Audit Process

Once a return is selected for audit, the IRS follows a general process:

• Notification: The IRS will notify the taxpayer by mail of the audit. The notice will specify the tax year(s) being audited and the type of audit (correspondence, office, or field).
• Information Gathering: The IRS auditor will request documentation and explanations to support the items under review on the tax return. Taxpayers are expected to cooperate and provide the requested information in a timely manner.   
• Taxpayer Rights: Taxpayers have several important rights during an audit, including:
  • Right to Representation: Taxpayers can hire an attorney, CPA, enrolled agent, or other authorized representative to represent them in dealings with the IRS. The representative can communicate with the IRS on the taxpayer’s behalf. 
  • Right to Record the Interview: Taxpayers have the right to make an audio recording of any in-person interview with the IRS, provided they give advance notice. The IRS also has the right to record the interview if they provide advance notice to the taxpayer. 
  • Right to Appeal: If a taxpayer disagrees with the audit findings, they have the right to appeal the decision within the IRS. 
• Audit Conclusion: At the conclusion of the audit, the IRS auditor will inform the taxpayer of their findings. There are three possible outcomes:
  • No Change: The IRS accepts the tax return as filed.
  • Agreed Change: The IRS proposes changes to the tax liability, and the taxpayer agrees with these changes. The taxpayer will typically sign a form agreeing to the adjustments and pay any additional tax owed, along with interest and potentially penalties.
  • Disagreed Change: The IRS proposes changes, but the taxpayer disagrees with the findings.
• 30-Day Letter and Appeal: If the taxpayer disagrees with the audit findings, the IRS will send a “30-day letter” (officially known as a Notice of Proposed Adjustment). This letter outlines the proposed changes and informs the taxpayer of their right to appeal the findings within 30 days. The appeal is handled by the IRS Independent Office of Appeals, which is separate from the IRS division that conducted the audit. 
• 90-Day Letter (Notice of Deficiency): If the taxpayer does not file an appeal within the 30-day period, or if they disagree with the outcome of the appeal, the IRS will issue a “90-day letter” (officially known as a Notice of Deficiency). This letter is the IRS’s final determination of the tax deficiency and gives the taxpayer 90 days to file a petition with the U.S. Tax Court to challenge the IRS’s determination before the tax is assessed and collection efforts begin.   

IRS Audit Technique Guides (ATGs)

Audit Techniques Guides (ATGs) help IRS examiners during audits by providing insight into issues and accounting methods unique to specific industries. While ATGs are designed to provide guidance for IRS employees, they’re also useful to small business owners and tax professionals who prepare returns. ATGs explain industry-specific examination techniques and include common, as well as, unique industry issues, business practices and terminology. Guidance is also provided on the examination of income, interview techniques and evaluation of evidence.

Selected topics:

Activities Not Engaged in for Profit Internal Revenue Code Section 183 

Attorneys Audit Technique Guide

Capitalization of Tangible Property

Cost Segregation

Equity (Stock) – Based Compensation Audit Techniques Guide

Taxpayer Penalties

The IRS can assess various penalties for non-compliance with tax laws. These penalties are intended to encourage taxpayers to file accurate returns, pay their taxes on time, and follow tax rules and regulations.   

§ 6662 of the Internal Revenue Code imposes penalties for underpayments of tax due to certain types of errors or misstatements. The penalty is generally 20% of the underpayment attributable to the following:  

• Negligence or Disregard of Rules or Regulations: Negligence includes any failure to make a reasonable attempt to comply with the tax laws or a careless, reckless, or intentional disregard of rules or regulations. This can include failing to keep adequate records or not exercising ordinary and reasonable care in preparing a tax return.
• Substantial Understatement of Income Tax: A substantial understatement of income tax occurs when the understatement exceeds the greater of:
  • 10% of the tax required to be shown on the return, or
  • $5,000 ($10,000 for corporations other than S corporations or personal holding companies).
• Valuation Misstatement: Penalties can be imposed for understating income tax by overstating the value of property or services (or their adjusted basis) claimed on the return, or by understating the value of property or services. The penalty rate can increase to 40% for gross valuation misstatements.  

Failure-to-File Penalty (§ 6651(a)(1))

§ 6651(a)(1) of the Internal Revenue Code imposes a penalty for failing to file a tax return by the due date (including extensions). The penalty is 5% of the unpaid taxes for each month or part of a month that the return is late, up to a maximum of 25% of the unpaid taxes. The penalty will not be imposed if the taxpayer can show reasonable cause for the delay. If the return is more than 60 days late, the minimum penalty is the smaller of $485 (for returns due in 2024; this amount may change annually) or 100% of the tax required to be shown on the return.

§ 6651(a)(2) of the Internal Revenue Code imposes a penalty for failing to pay the tax shown on a return by the due date. The penalty is 0.5% of the unpaid taxes for each month or part of a month that the tax remains unpaid, up to a maximum of 25% of the unpaid taxes. This penalty can be avoided if the taxpayer has reasonable cause for the failure to pay and pays the tax as soon as possible.

§ 6656 of the Internal Revenue Code applies to businesses that fail to deposit employment taxes (such as Social Security, Medicare, and withheld income taxes) and certain other taxes on time. The penalty rate depends on how late the deposit is:

• 2% if the failure is for not more than 5 days
• 5% if the failure is for more than 5 days but not more than 15 days
• 10% if the failure is for more than 15 days or on or before the day of the first delinquency notice from the IRS
• 15% if the tax is not deposited within 10 days after the first delinquency notice or on the day of demand for immediate payment

Fraud Penalties (§ 6663 and § 7201 et seq.)

Fraud penalties are the most severe and are imposed when the IRS determines that a taxpayer intentionally attempted to evade or defeat tax.

• Civil Fraud (§ 6663): If any part of an underpayment is due to fraud, a penalty of 75% of the underpayment attributable to fraud will be added to the tax.  
• Criminal Fraud (§ 7201 et seq.): In addition to civil penalties, taxpayers who willfully attempt to evade or defeat tax can face criminal prosecution, which may result in fines, imprisonment, or both. Examples of criminal tax fraud include filing false returns, concealing income, and destroying records.   

Information Return Penalties (§ 6721 et seq.)

The IRS imposes penalties for failing to file correct information returns (e.g., Form 1099, Form W-2) by the due date or for failing to furnish correct information statements to recipients. The amount of the penalty generally depends on how late the return or statement is filed or furnished and whether the failure was intentional.

Interest on Underpayments and Over-payments (§ 6601 et seq., § 6611 et seq.)

In addition to penalties, interest may be charged on underpayments of tax from the due date until the tax is paid. Conversely, the IRS also pays interest on over-payments of tax, generally from the date of the over-payment until a date determined by the IRS. The interest rate is adjusted periodically.   

Navigating the complexities of IRS audits and understanding the potential for taxpayer penalties can be challenging. It is crucial for taxpayers to maintain accurate records, file their returns on time, and pay their taxes when due. If faced with an IRS audit, taxpayers should understand their rights and consider seeking professional assistance from a tax advisor.

§ 6664(c) of the Internal Revenue Code provides an exception to the accuracy-related penalties if the taxpayer had reasonable cause for the underpayment and acted in good faith. Whether reasonable cause exists is determined on a case-by-case basis, taking into account all the facts and circumstances. 

For complete details visit the IRS page on Penalty Relief for Reasonable Cause.