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A Step-by-Step Guide on IRS Tax Audit for Every Type of Taxpayer

"Tax Audit" handwritten on business accounting documents

Tax audits are something that every taxpayer dreads and hopes doesn’t come knocking on their door. But while terrifying, tax audits serve an important purpose. Knowing how they work and how to deal with them can make this otherwise scary endeavor less daunting.

From different types of taxpayers to how expats can avoid being audited, this will serve as your ultimate guide on how IRS tax audits are conducted and how to prepare for them.

What are the Different Types of Taxpayers?

Knowing which type of taxpayer you are can help you determine your options when dealing with tax audits. According to the Internal Revenue Service (IRS), international taxpayers can be classified as either of these three types:

  1. U.S. citizens and resident aliens abroad

    You are categorized as a resident alien of the United States by the IRS if you meet one or both requirements for the calendar year: a substantial presence test or a green card test.

    If you’re a resident alien, the rules for filing estate, income, gift tax returns, and paying estimated tax typically correspond with U.S. tax standards. Whether you’re abroad or in the United States, your worldwide income tax is subject to U.S. tax income, much like a U.S. citizen.

  2. Foreign persons

    The IRS classifies the tax information for foreign persons as the following: resident aliens who passed the green card test or substantial presence test in the current calendar year and nonresident aliens who did not meet the green card or substantial presence test.

    Aside from resident and nonresident aliens, dual-status aliens, individuals who changed residency status in the same calendar year, and international students who temporarily live in the United States to study are classified as foreign persons.

    Other taxpayers who fall under the category are athletes, entertainers, au pairs, agricultural workers, and expatriates.

  3. U.S. territory taxpayers

    If you work or live in U.S. territories like American Samoa, Guam, Puerto Rico, the Commonwealth of Northern Mariana Islands (CNMI), or the U.S. Virgin Islands, you must file a tax return with the territory’s tax department.

    Certain situations may prompt you to verify whether you’re a resident or nonresident of the territory. If you receive income from one of the U.S. territories, you may need to file a U.S. tax return, a territory tax return, or in some cases, both, depending on if you’re a certified U.S. territory citizen.

Tax Audits: Why Does the IRS Conduct Them?

The primary purpose of tax audits is to determine whether reports like income or deductions filed with the proper taxing authorities are accurate. Being audited does not necessarily mean you’ve committed an offense against the IRS; the appropriate tax authority has the right to conduct a closer examination of your returns as they see fit.

Fast Facts and Statistics

  • According to the IRS Data Book of 2020, the taxpayer’s chance of being audited is a measly 0.6%, meaning the IRS only audit one out of every 166 tax returns.
  • The IRS typically audits less than 1% of all filers.
  • Around 150 million total federal tax returns are filed annually
  • Close to 90% of audits result in a tax return change.

Tax audits are more common than you thought. Eventually, all citizens will be subjected to audits, as it’s customary for a responsible citizen to go through.

4 Types of IRS Audits

  1. Correspondence Audits

    A correspondence audit refers to an IRS tax audit process conducted by phone call or conventional mail.

    The correspondence audit process entails the IRS sending the organization a written request, or the IRS Letter 566, to gain additional information about a particular issue or item on their tax return.

    This type is considered the lowest level of audit. Aside from a Letter 566, receiving a CP2000 notice usually entails you may undergo a correspondence audit.

    A CP2000 notice, otherwise known as an underreporter inquiry, will be sent to the taxpayer if their returns do not accurately mirror what the IRS has on record. Additionally, a CP2000 notice is sent to propose an adjustment for under or overpayment of tax obligations.

  2. Office Audits

    If the IRS has inquiries that are too complex or vast for a correspondence audit but not at the level of a field audit, you will be sent a letter asking you to appear in person at an IRS office for an audit.

    In an office audit, you will be asked questions about the issue under examination. This may include generalized questions about your financial position, employment, and lifestyle to find other causes for concern, like the possibility of underreported income.

    It’s best to bring a CPA or a tax professional to accompany and represent you. These professionals will ensure that your answers and actions won’t expand the IRS’s inquiries beyond those specified in the audit letter.

  3. Field Audit

    A field audit is the most extensive type of IRS tax audit. This entails IRS revenue agents visiting your home, place of business, or your accountant’s office to see information outside of certain records, not wanting to limit themselves to a particular item.

    If you’re a business owner, your typical field audit will consist of reviews regarding your financial records, employee interviews, and a business facility tour. These interviews will ensure an overview of internal controls, accounting procedures, and management structure.

    As for individual taxpayers, the field audit only entails a review of financial records and an interview with the taxpayer. Depending on the complexity of the matter, field audits may last from one day to a week.

    Field audits are considered the most intrusive type. Any information you may divulge may be used against you to broaden the scope of an audit, so it’s best to enlist the services of a tax professional like a tax attorney to aid you in these proceedings.

  4. Line-by-Line Audit

    Line-by-line audits are the most unpredictable, as the IRS chooses a taxpayer at random. If selected, the IRS will extensively analyze your tax return to establish norms or benchmarks that can trigger future audits of this nature. Some taxpayers subjected to a line-by-line audit may owe additional taxes, penalties, and interest.

How Different Types of Taxpayers Can Resolve Tax Audits

Now that we’ve identified the different types of taxpayers and audits, let’s discuss actionable ways you must keep in mind to resolve tax audits.

  1. Identify what type of audit will be conducted

    Identify the audit type you’ll undergo, then prepare the necessary information or file for a postponement if you require more time. Whether in-person or by correspondence, dealing with the IRS requires the expat to be honest, accurate, polite, and courteous; reply to notices issued within the allotted time.

    Additionally, it’s essential to keep all records related to your foreign income, taxes, and expenditures for at least three years to ensure that an honest error isn’t misinterpreted as tax evasion if audited.

  2. Know why you’ve been selected for an audit

    It’s imperative to know why you’ve been selected for an audit. For foreign taxpayers like expats, failure to submit necessary forms like the Foreign Bank and Financial Accounts Report (FBAR) could be one of the causes.

    The FBAR or FinCEN Form 114 must be submitted yearly by qualified taxpayers. This foreign bank account report exists to combat tax evaders by requiring U.S. citizens to report money and assets in non-U.S. bank accounts.

    Expats who fail to comply can be subjected to an audit and incur heavy penalties. Keep in mind the regular submission of your FBAR to avoid troublesome audits.

  3. Submit your IRS Form 8398

    IRS Form 8398, a more comprehensive reporting of foreign assets, is one of the most important requirements to fulfill as an expat. It is utilized to report an expat’s specified foreign financial assets due to their total value exceeding the appropriate reporting threshold.

    The expat reports their savings deposits, checking, and brokerage accounts. Additionally, stocks or securities issued by a non-U.S. citizen must be reported. Submission is a must to avoid an audit and incur upwards of $50,000 in penalties for severe offenses.

  4. Involve your tax professional throughout the process

    Tax matters are complicated, and an ordinary citizen will find it challenging to deal with this process alone, making it best to hire a competent tax professional for help.

    It’s recommended to sign a power of attorney that allows the IRS to talk directly to your tax professional. But even without a power of attorney, your tax professional should be present in any proceedings concerning your audit as they can properly guide you in resolving your tax audit issues.

Tax Filing Preventive Measures for Expats

While an IRS audit isn’t something to panic about, it’s still useful to learn some helpful tips, best practices, and actionable recommendations to keep your taxes up-to-date.

  1. Account for all your income

    While some may be tempted to underreport income on their tax return, it’s not a good idea. Report all income to the IRS regardless of the method of payment. Failure to report all income may result in having to pay back taxes with additional penalties.

    Read: 5 Things You Should Know About Foreign Source Income

  2. Double-check your tax return before you file

    Tax returns with simple mathematical errors can already prompt an audit from the IRS, making it crucial to review your tax returns before filing them. Ensure that all the columns add up and the total dollar value of capital gains and losses are correctly calculated.

    Read: 6 Tax Audit Mistakes & How to Avoid Them

  3. Keep your financial records organized and updated

    Tax compliance problems can be easily avoided by keeping your financial records up-to-date. Creating an accurate financial report will be much easier if you set aside time to extensively review payments, invoices, and other essential things to consider.

    Read: How to Effectively Organize Your Tax Records

  4. Consult with a tax professional

    Whether you’re dealing with a tax audit or trying to prevent it, consulting with a tax professional is always recommended. Receiving help from certified tax professionals can boost your tax compliance efforts.

    Tax professionals possess a wealth of experience in helping corporate or individual taxpayers become tax compliant and an understanding of tax requirements and laws.

Knowing is Half the Battle

Being subjected to tax audits is one of the most stressful endeavors citizens could ever encounter. Tax laws are complicated, and processes are arduous. However, arming yourself with the knowledge regarding audits, their types, and why they are done gives you valuable insights to deal with this situation if you’re ever faced with it.

Additionally, you can seek help from tax professionals. They’ve dedicated their professional lives to this cause, helping the uninitiated resolve their tax-related issues.

If you require excellent tax preparation services, look no further than Tax Samaritan. Serving expats since 1997, Tax Samaritan provides professional-quality tax resolution services to aid in intricate tax-related matters. Get a free tax quote today with Tax Samaritan and start your tax return efforts.

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