How far back can IRS audit: Common audit triggers

Taxpayers, especially US expats, often stress about tax audits because they have no idea what years can the IRS audit their filed (or, sometimes - NON-filed) tax returns.

So, how far back can the IRS audit?

The simple answer is - it depends on your specific scenario. If you have fulfilled the FBAR (foreign bank accounts reports) reporting requirements up till now then the IRS has 3 years to audit your expat returns. If it’s not up to date then the 3 years are extended to 6 years.

However, there are exceptions. The IRS audit statute of limitations ceases to apply and the period of audit can become indefinite if you:

• Have never filed a tax return;
• Forgot to sign your tax return;
• Filed fraudulent returns in the past.

In this article, we are going to mainly look at audit triggers as well as what happens if you get audited.

Why can I be selected for an audit?

A tax audit is a review of a business or individual’s return by the IRS to verify that the filed return is accurate and everything reported in it is in compliance with the existing tax laws. But what triggers an IRS audit?

The following reasons will cause a tax man to knock at your door.

1. Random selection by the computerized screening system

The IRS uses a computer scoring system based on a statistical formula to select returns for tax audits. Computer audit specialists follow specific IRS guidelines when using statistical sampling audit techniques.

2. Being related to someone who is being scrutinized by the IRS

You are likely to get hit by the IRS audit if someone related, such as your business partner, is already under audit.

3. Being a high earner

High earners' probability for a tax audit is much higher. In May, 2022 the IRS released data for the year 2019 where the audit rate was doubled for taxpayers in every income category above $100,000 within 7 months.

Here is the data extracted from the IRS statement. The table illustrates the comparative audit rate for income above $500,000.

 

NOTE! “TPI is the aggregate sum of all the positive amounts from multiple sources of income excluding losses.”

4. Making generous charitable donation

Charitable donations get tax incentives but the IRS keeps an eye on generous donations. Donations through bank transfer can be traced easily, but when you donate property a fair market value assessment is required to account for it in your return.

This gets tricky and will grab the auditors' attention.

5. Mathematical errors

It might sound simple but mathematical errors can put the reviewer on high alert. It might be an innocent mistake on your part but it can cause auditors to come after you. So, be vigilant.

6. Being self-employed

Self-employed people get hit by audits more often. This is because the IRS offers generous tax benefits to them, so there is room for exploitation.

There are four main causes to consider here:

I - Excessive deductions

Excessive deductions raise red flags. Ordinary and necessary business expenses are allowable deductions. But the IRS keeps a close eye on home office deductions, meal expenses, and those vehicles that self-employed people use exclusively for business.

II - Distinguish between independent contractors vs employees

Businesses prefer hiring independent contractors to avoid paying social security and Medicare taxes. If you are offering services as an independent contractor make sure you meet all the criteria for being one.

The degree of control and independence you enjoy while offering your services will determine whether you are an independent contractor or an employee.

III - Cash-intensive business

Certain businesses, like convenience stores, are cash intensive. To prevent underreported income the IRS keeps a close watch on such businesses.

IV - Continuous business losses

It is common for startups to report losses in the early years of their operation but consistent losses will raise red flags. The IRS will also investigate whether you are pursuing a hobby or running a business as they only allow business expense deductions, not hobby expenses.

7. Claiming earned income tax credit

Most rural and low-income earning taxpayers claim Earned Income Tax Credit (EITC). It facilitates low and moderate-income individuals and families to reduce the taxes they owe.

According to the IRS update it has been estimated that out of more than $64 billion in EITC benefit, paid to $26 million taxpayers in 2017, 50% of claims have errors. So this is one area on the IRS radar.

8. Drastic changes in revenue or expenses

When you run a business for several years there is a level of predictability where you can project your future revenues and expenses based on historical financial performance.

Whether it was a good or a bad year, it will be reflected in your financial statements and - in turn - in your tax return.

NOTE! However, if the IRS spots a dramatic increase in your income or expenses they might consider you a potential candidate for audit.

How will the IRS conduct my audit?

The IRS will initially get in touch with you by mail which will contain all the guidelines and contact information. Generally, your audit may fall into one of these categories:

• Correspondence audits. The IRS will conduct correspondence audits via mail or electronically. It involves reviewing specific items on your tax return. The IRS will request the necessary documents and will give you reasonable time to respond to their request.
• Office audit. In an office audit, you are required to meet the IRS auditor at a local IRS office. The auditor will review your records along with all the supporting documentation. You may be asked to provide additional information.
• Field audit. In a field audit the IRS auditor will visit your business location or residence to review a wide range of records and documents such as bank statements, financial statements, receipts, and invoices. They may ask you for additional information.

What do I need to provide during an audit?

The IRS will send you a list of required documents for audit in writing. They might ask you to provide the following documentation to support your reported income, claimed deductions, and credits:

• Receipts with dates & notes on their purpose and how it is related to your business;
• Bills mentioning the payment dates & the name of the receiver;
• Canceled checks;
• Legal documents.

To make sure that the IRS received every correspondence and sent documents you can request confirmation from your delivery services.

NOTE! Taxpayers often wonder “how many years of tax returns to keep”.  The law requires you to keep the records of documents for at least 3 years.

How far back can the IRS audit past tax returns?

This mostly varies on a case-to-case basis. As a general rule, the IRS can audit returns filed within 3 years.

The 3 years become 6 years when the IRS finds the omission of more than 25% of gross income.

Also (did you know?):

• How far back can the IRS go for unfiled taxes? - Forever! If an auditor encounters omissions of tax forms or suspects fraud the statute of limitation is no longer applicable and they can audit your returns indefinitely. This can lead to the IRS imposing heavy penalties on you.
• How long it takes to conclude an audit? - It may take a few months to a year depending on the complexity, availability of the required documents, and the type of audit.

What are my rights when the IRS concludes an audit?

There are two ways the IRS can conclude your audit.

1. Proposed “No changes”

Proposed “no changes” as a result of the IRS examination. This means that everything reported is backed up with evidence and they found no irregularity.

2. Proposed changes

Proposed changes as a result of the IRS examination. This will result in one of the following two scenarios.

• Agree. If you agree with the proposed changes you will be presented with an examination report or form to sign. Use the available payment option if you owe additional taxes to the IRS.
• Disagree. If you disagree with the proposed changes you can either:
  
  
  • Seek help from Alternative dispute resolution to mediate between you and the IRS;
  • File an appeal provided that the statute of limitation is still intact.

As a taxpayer, you have the following rights:

a) Be informed

This means you have the right to:

• Know the reason you are required to provide information to the IRS while filing a tax return or being audited;
• Be informed about the IRS decisions and the outcome of your tax audit;
• To get clear explanations of all the tax laws, regulations, and procedures.

b) Challenge the IRS’s position

If you disagree with the audit conclusion you have the right to challenge it. You can seek assistance from IRS mediation services and expect to be heard.

If the matter remains unresolved you have the right to appeal on an independent forum for a fair hearing. If the conflict still persists you can go to court.

NOTE! Before you take the matter to court it would be wise to discuss the possible outcome with a tax & legal expert.

c) Privacy and confidentiality

Any enforcement actions and inquiries from the IRS will not be more intrusive than necessary and any information you provide them will not be disclosed unless you authorize them or it is required by law.

d) Representation

You can authorize enrolled agents, CPAs, or attorneys to represent you in audit and payment collection issues. These tax professionals have unlimited representation rights because of their qualifications and credentials as tax preparers.

Where can I get help to deal with an audit?

Some tax audits are more in-depth and are a cause for concern. This happens when either you have something to hide, or the IRS has incriminating information.

As soon as you receive a letter from the IRS you might have no idea about the outcome…

But a pro tax specialist can predict the outcome based on years of experience. It is prudent to adopt a preventive strategy - to turn to a tax pro while preparing your taxes.