What it means
Tax authorities check returns to confirm that income is reported correctly and that deductions and credits are valid. The Internal Revenue Service uses three broad types of audit.
A correspondence audit is handled by mail, an office audit takes place at an IRS office, and a field audit is carried out by an agent at the taxpayer's home or business. An office audit begins with a letter that names the items to be reviewed, such as business expenses, charitable gifts or certain credits, and gives a date and place to attend.
The taxpayer is asked to bring the records that support those items, such as receipts, bank statements and mileage logs. An accountant or other authorised person can attend instead of, or with, the taxpayer.
During the meeting, the auditor examines the documents and asks questions. If an item is not supported, the auditor can disallow it, which raises taxable income and increases the tax owed.
The taxpayer may also owe interest and penalties, and can agree with the findings or disagree and use the appeals process. Good records are the best protection.
Businesses should keep invoices, receipts and an explanation of why each expense relates to the business. As a general principle, a tax authority has a limited period after a return is filed in which it can normally audit it, although longer periods can apply in cases such as serious under-reporting.
For finance teams, an audit letter should be dealt with promptly and calmly. Check the dates and the scope, gather exactly what is asked for, and consider professional help for anything complex.
Responding carefully tends to limit the audit to the items listed.
In practice
Real-world examples.
Example
A freelance photographer receives a letter asking her to bring proof of her $15,000 equipment and travel claims. She attends with receipts and a mileage log. The auditor accepts all but $1,200 of the expenses.
Example
A small bakery owner is audited on cash sales after the reported income looks low compared with similar bakeries. His accountant attends with till records and bank deposits. The reconciliation explains the gap and no change is made.
Example
A consultant claims a home office deduction and is asked to attend an office audit. She brings floor plans, utility bills and photos showing the space used only for work. The auditor allows the deduction in full.
Formula
Calculation
Additional tax owed = disallowed deduction x marginal tax rate
Penalty (if applied) = additional tax x penalty rate
An office audit disallows $20,000 of business expenses that the owner could not support with receipts. Assume a marginal tax rate of 24%. Additional tax = 20,000 x 0.24 = $4,800. If an accuracy penalty of 20% applies, the penalty = 4,800 x 0.20 = $960, giving $5,760 before interest. The rates are used here only for illustration and are set by the tax authority.Case study
Seen in the real world.
Riverside Design Studio is a fictional business used to illustrate an office audit. In this illustrative story, the owner received a letter asking him to support $40,000 of expenses claimed on his return, including travel and client meals. He had kept receipts in a shoebox with no notes on who attended each meal or why the trip took place.
His accountant spent two days organising the papers and writing short explanations before the meeting. The auditor accepted $34,000 of the claims and disallowed $6,000 for which there was no clear business purpose, which at a 24% rate meant $1,440 of extra tax. Riverside now scans receipts into its accounting system and adds a note to each expense on the day it is paid.
The audit also changed how Riverside works with its adviser. The accountant now meets the owner every quarter to review expenses and flag anything that looks unusual, so that a future letter from the tax authority can be answered from well-organised files within a day.
Watch out
Common mistakes.
- Ignoring the audit letter. Missing the date or failing to respond can lead to the auditor disallowing items by default.
- Bringing everything instead of what was requested. Provide only the records related to the items named, organised and clearly labelled.
- Going alone to a complex audit. A qualified tax adviser can speak for the taxpayer and help avoid costly admissions.
Questions
People also ask.
What is the difference between an office audit and a field audit?
An office audit takes place at the tax authority's office and covers limited items, while a field audit takes place at the taxpayer's premises and is usually broader.
Can I send someone to represent me?
Yes, an accountant, attorney or other authorised representative can usually attend on your behalf.
What if I disagree with the result?
You can usually appeal within the tax authority and, if needed, to the courts, following the process described in the audit report.
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