How to Respond to an IRS Audit in 2022 Part 1
IRS Letter 6323 and What to Do Before Contacting IRS
Small business owners should be prepared in case the Internal Revenue Service decides to audit your business. Watch part one of our three part series for advice on how to defend your business against a battle with IRS. In this video, our founder and managing attorney, John Milikowsky explains five things to do before you respond to an IRS audit letter.
Identify the Taxpayer
Before diving into your audit letter, first identify who the taxpayer is on the top left corner of the letter. If the letter is addressed to you as an individual, IRS is primarily looking at your 1040 return.
This can include other companies you own or control where the income and/or losses are being reported on your individual return.
If the letter addresses your company’s name, then you can expect a broader audit. A broader audit can impact other shareholders and partners.
Identify the Revenue Agent
After identifying the taxpayer, review who the revenue agent is. The revenue agent can be located either inside of your city or outside of your city.
If the agent is located outside of your city, we recommend you question why.
Recently, we defended a client in a battle against IRS. The client is based in Los Angeles, but their revenue agent was based in Chicago, Illinois. This identified larger issues at play- IRS was potentially looking at not only this tax return but possibly other tax returns as well. In this case, they could be part of a broader, national audit.
Identify the Tax Year Being Audited
Confirm the tax years IRS is auditing. Ask yourself, “Is it a single-year audit?” or “is this audit for more than one tax year?”
Typically IRS will audit three years of tax returns. Initially, they may begin with a single-year audit. Depending on the results of the audit, they’re may explore other years to identify a trend.
IRS can audit as far back as 6 years, if there’s gross understatement of income. If there is fraud involved, IRS can audit an unlimited number of years.
Typically, if IRS is looking at a 5-year block of time, they are looking at a potential fraud issue- which could lead to a criminal investigation. Before they can determine if a case involves fraudulent activity, IRS will review your returns in detail to identify any incriminating information.
Identify the Issue(s) that Triggered the Audit
Read the audit letter to identify what issue(s) are being identified for audit. This is not an expensive all-inclusive list, however, it is a starting point for IRS.
During an audit, IRS always reviews income on tax returns and evaluates if that information reported was accurate, not understated. How do they evaluate your income statement is accurate? IRS does so by conducting a bank deposit analysis: they collect all of your bank statements, both personal and business, to determine whether you reported the correct amount of income.
When assessing income, there are times income for an individual may be reported in a business account or vice versa. During the audit, IRS ensures they capture all of your transactional information, and that it’s accurately being reported. Anticipate IRS asking for:
- Bank statements
- Cancelled checks
- Deposit images
IRS also looks at your expenses. When looking at your expenses, they are looking for source documents, such as, invoices. They are checking payments, to verify that you not only incurred the expense, but also that you paid for it.
The purpose of gathering this information is to verify the deposits are income and not non-taxable income such as insurance proceeds that would not normally be taxed. The only way IRS can reach that bottom line number is by reviewing the source documents.
Identify the Response Deadline
IRS will identify a deadline by which you must respond to their letter by. Generally, the revenue agent will give you 10 days to respond to the initial letter- you are not yet providing the documents requested. This initial response serves the purpose of:
- Contacting the the revenue agent
- Scheduling an appointment to provide the requested records
During the first appointment, you will go through an interview with your assigned IRS agent. Your agent will walk through a whole litany of questions to understand:
- The scope of what income looks like for you
- Whether you received an inheritance for instance
- Whether you received any large transfers
- Whether you have any cryptocurrency
- And more
Best practice is to contact a tax attorney to review the questions ahead of time. Credibility is one of your most valuable assets during an audit. When you first meet with IRS and communicate with them, their agents will judge whether you’re credible and whether the information you’re providing is forthcoming and truthful. If IRS deems you are not, they will launch a deeper dive.
For more information on IRS audits in 2022, read the second part of our series by clicking the link here.