How the IRS Audit Process Works

Receiving a letter from the Internal Revenue Service stating that your tax return has been selected for examination can be unsettling. For many taxpayers, the word audit immediately raises concerns about large tax bills, penalties, or even criminal investigations.

Fortunately, most of those fears are misplaced. An IRS audit is simply the government’s process for verifying that information reported on a tax return is accurate and supported by the available records. While some audits result in additional tax, many are resolved with little or no change to the original return.

The important point is this: An IRS audit is an examination — not a conclusion.

What Is an IRS Audit?

An IRS audit — officially referred to as an examination — is the IRS’s review of one or more items reported on a federal tax return. The objective is to determine whether the tax return accurately reflects the taxpayer’s income, deductions, credits, and other tax positions.

Depending on the circumstances, the examination may focus on a single issue or encompass nearly every aspect of a taxpayer’s financial activity. Some examinations require only a handful of supporting documents. Others involve thousands of pages of accounting records, bank statements, invoices, payroll reports, contracts, and financial analyses.

An audit may involve questions regarding:

• Business income
• Self-employment expenses
• Rental real estate
• Charitable contributions
• Cryptocurrency transactions
• Brokerage activity
• Partnership allocations
• S corporation basis
• Officer compensation
• Cost basis calculations
• Depreciation
• Payroll tax issues
• Foreign financial reporting
• Net operating losses

What an IRS Audit Is Not

Popular culture often portrays IRS audits as dramatic confrontations involving surprise visits, criminal investigators, or immediate collection action. In reality, most examinations are considerably more routine.

An IRS audit is not automatically evidence that fraud has occurred, proof that additional tax is owed, a criminal investigation, punishment for making a mistake, or an indication that your return was prepared incorrectly.

Many taxpayers are selected simply because additional documentation is needed to support a particular item reported on the return. In fact, it is possible for an audit to conclude with no change to the return, a relatively small adjustment, removal of a proposed adjustment after documentation is provided, or, in limited circumstances, an additional refund.

Civil Audits vs. Criminal Investigations

One source of anxiety for many taxpayers is the fear that an audit could suddenly become a criminal tax investigation. Fortunately, criminal investigations represent only a very small percentage of IRS enforcement activity.

Most IRS audits are civil examinations. Their purpose is to determine the correct amount of tax — not to pursue criminal prosecution. Civil examinations are generally conducted by IRS Revenue Agents or Tax Compliance Officers.

Criminal tax investigations, by contrast, are conducted by IRS Criminal Investigation Special Agents and involve entirely different procedures. While a civil examination can occasionally uncover evidence that leads to a criminal referral, that outcome is uncommon. For the overwhelming majority of taxpayers, an IRS audit remains a civil matter focused on substantiating items reported on the return.

Your Rights During an IRS Audit

Congress adopted the Taxpayer Bill of Rights to help ensure taxpayers are treated fairly throughout every interaction with the Internal Revenue Service. Although many taxpayers have heard of these rights, few understand how they apply during an examination.

Why the IRS Audits Tax Returns

One of the first questions almost every taxpayer asks is: “Why did the IRS choose my return?” The truthful answer is that there usually is not a single reason.

The IRS uses numerous methods to identify returns for potential examination. Some rely upon sophisticated computer scoring models. Others involve information received from third parties. Some arise because another taxpayer is already under examination. Still others are selected as part of broader compliance initiatives.

The IRS Cannot Audit Every Return

Each year, the IRS processes hundreds of millions of tax returns and receives billions of information documents from employers, banks, brokerage firms, payment processors, partnerships, and other reporting entities. It would be impossible for IRS employees to manually review every return.

Discriminant Information Function, or DIF

One of the best-known IRS selection tools is the Discriminant Information Function, commonly referred to as DIF. Although the IRS does not publicly disclose the exact formula, the general concept is widely understood. The system compares tax returns against statistical norms developed from millions of previously filed returns and completed examinations.

A higher DIF score does not mean the return is incorrect. Nor does it mean the taxpayer violated the law. It simply indicates that the return contains characteristics that statistical models suggest may warrant additional review.

Information Matching

Employers, banks, brokerage firms, payment processors, partnerships, S corporations, and other organizations file information returns with the IRS. When those forms do not match the taxpayer’s return, the IRS may request an explanation.

Receiving the IRS Audit Notice

For most taxpayers, the audit process officially begins with a letter from the Internal Revenue Service. The notice identifies the tax year under examination, the issues the IRS wants to review, and what the taxpayer is expected to do next.

While the notice itself may only be a few pages long, it establishes the framework for the entire examination. Before gathering records or contacting the IRS, take the time to read the notice carefully.

What Information Does the Notice Contain?

• The tax year or years under examination.
• The date by which you must respond.
• The IRS office handling the examination.
• Contact information for the assigned examiner.
• A description of the issues being reviewed.
• A request for documentation supporting those items.
• Instructions regarding how the response should be submitted.

Not Every IRS Notice Is an Audit

Taxpayers often receive notices regarding mathematical corrections, balance due issues, identity verification, or automated matching programs that are not examinations in the traditional sense. Because IRS notices vary significantly, we maintain a separate IRS Notice Library explaining common notices and what each one means.

Before Responding, Determine the Scope of the Examination

One of the most important questions during the early stages of an audit is surprisingly simple: What exactly is the IRS examining?

Many taxpayers assume the IRS is reviewing the entire return. Sometimes that is true. Often it is not. An examination may focus on one deduction, one source of income, a specific tax credit, basis in property, depreciation, business expenses, one rental property, or another isolated issue.

Understanding the scope of the examination allows you to focus your response on the issues that actually matter. Responding to issues the IRS never questioned can unnecessarily complicate the examination and create additional work for both the taxpayer and the examiner.

Organizing Your Records Before You Respond

Once the issues under examination have been identified, the next step is assembling the documentation that supports the tax return. This sounds straightforward. In practice, it is often where taxpayers begin making avoidable mistakes.

The objective is not to gather every financial document you possess. Instead, the goal is to identify the records that directly support the issues under examination and present them in a manner that allows the IRS to efficiently evaluate your position.

Records the IRS May Request

• Bank statements
• Canceled checks
• Receipts and invoices
• Contracts
• Mileage logs
• Brokerage statements
• Settlement statements
• QuickBooks reports
• General ledgers
• Payroll reports
• Depreciation schedules
• Partnership agreements
• Shareholder records

What If Records Are Missing?

Missing documentation does not automatically mean an issue is lost. Businesses change accounting systems. Receipts are misplaced. Banks merge. Electronic records become inaccessible.

The important question becomes whether the underlying transactions can be reasonably substantiated through other reliable evidence. Depending on the circumstances, alternative documentation, summaries, third-party records, accounting reports, reconstructed schedules, or other contemporaneous evidence may help establish the taxpayer’s position.

Information Document Requests, or IDRs

In more complex examinations, the IRS may issue what is known as an Information Document Request, commonly referred to as an IDR. An IDR is a formal request identifying the documents or information the examiner wants to review.

Rather than requesting “all records,” a properly prepared IDR typically identifies specific categories of information, the tax periods involved, and a deadline for production. Because IDRs often become the roadmap for the remainder of the examination, they deserve careful review before documents are produced.

What Happens After the Records Are Submitted?

Once documentation has been produced, the examination enters a new phase. The IRS begins evaluating the information, comparing it to the tax return, reconciling records, and determining whether additional questions remain.

In some cases, the records fully support the return and no further information is needed. In others, the examiner may issue additional requests, schedule interviews, seek clarification regarding specific transactions, or identify issues that require further development.

How the IRS Evaluates the Information You Provide

Once the requested documentation has been submitted, the examination enters what is often the longest phase of the audit. The IRS now evaluates whether the information provided substantiates the positions taken on the tax return.

This review involves considerably more than verifying whether receipts exist. The examiner is attempting to determine whether the documentation is complete, credible, internally consistent, consistent with third-party information, consistent with the taxpayer’s books and records, and sufficient under the Internal Revenue Code and applicable Treasury Regulations.

Depending on the complexity of the case, this review may take several weeks or several months. Business examinations involving multiple entities, numerous bank accounts, accounting software, or large volumes of transactions often require significantly more analysis than an individual correspondence examination.

Additional Questions and Follow-Up Requests

It is common for an examiner to have additional questions after reviewing the initial records. Receiving a second request for information does not necessarily indicate that the examination is going poorly. Instead, it often reflects the natural progression of the audit.

• A receipt references another transaction.
• Accounting records require clarification.
• Bank deposits do not reconcile exactly with reported income.
• Depreciation schedules require supporting documentation.
• Shareholder basis calculations are incomplete.
• A business activity affects multiple tax years.

IRS Interviews

Not every examination includes an interview. However, interviews are relatively common during office and field audits, particularly when business activities are involved.

The purpose of an interview is generally to understand how the taxpayer earns income, how books and records are maintained, who performs accounting functions, how expenses are approved and documented, how internal controls operate, and how particular transactions occurred.

Common Interview Mistakes

• Guessing when the correct answer is unknown.
• Speculating about accounting entries.
• Answering questions that were not asked.
• Attempting to estimate figures from memory.
• Contradicting previously submitted documentation.
• Volunteering information unrelated to the examination.

Proposed Examination Findings

After completing the review of the available information, the examiner reaches preliminary conclusions regarding the tax return. These conclusions are generally presented in an examination report identifying any proposed adjustments.

• Additional taxable income
• Disallowed deductions
• Changes to depreciation
• Revised basis calculations
• Payroll adjustments
• Penalty recommendations
• Interest calculations

Proposed adjustments are exactly that — proposed. At this stage, the taxpayer generally has an opportunity to review the examiner’s conclusions, identify factual errors, provide additional documentation, explain transactions that may have been misunderstood, cite applicable legal authority, and determine whether the proposed changes should be accepted or challenged.

Penalties

In addition to proposing additional tax, the IRS may also recommend penalties. Common civil penalties include accuracy-related penalties, failure-to-file penalties, failure-to-pay penalties, and information reporting penalties.

Whether a penalty ultimately applies depends on the specific facts, applicable law, and available defenses. In appropriate cases, taxpayers may request penalty relief based on reasonable cause or other statutory provisions.

When You Disagree With the IRS

Not every taxpayer agrees with the examiner’s conclusions. Fortunately, disagreement does not automatically mean litigation is necessary. The IRS examination process includes opportunities to seek additional review before the matter reaches court.

Many disputes are resolved administratively through the IRS Independent Office of Appeals. Appeals serves a different function than Examination. Rather than developing the facts, Appeals evaluates the strengths and weaknesses of both positions and attempts to resolve disputes without litigation whenever possible.

The IRS Independent Office of Appeals

Appeals Officers generally consider the facts developed during the examination, the documentation supporting each position, applicable statutes and regulations, relevant court decisions, and the potential hazards of litigation.

Learn more on our dedicated page: IRS Audit Appeals.

Possible Outcomes of an IRS Audit

Common Mistakes During the IRS Audit Process

• Ignoring the audit notice.
• Missing response deadlines.
• Assuming the IRS is reviewing the entire return without confirming the scope.
• Producing documents that were never requested.
• Submitting disorganized records.
• Failing to reconcile accounting records before production.
• Guessing during interviews.
• Attempting to reconstruct facts from memory rather than documentation.
• Waiting until the audit has progressed before seeking professional advice.
• Assuming every proposed adjustment must be accepted.

Frequently Asked Questions

How long does an IRS audit usually take?

Simple correspondence examinations may conclude within several months, while complex business examinations can continue for a year or longer.

Can the IRS audit more than one year?

Yes. If the IRS identifies issues affecting multiple tax years, the examination may expand beyond the year initially selected.

Can the IRS audit a return that was professionally prepared?

Yes. Preparation by a CPA, enrolled agent, or attorney does not prevent an examination. The audit focuses on the accuracy and supportability of the return.

Do I have to meet with the IRS myself?

Not always. Depending on the circumstances, a properly authorized representative may handle many communications with the IRS on your behalf.

Can additional documentation change the outcome?

Yes. Many proposed adjustments are modified or withdrawn after additional documentation or clarification is provided during the examination.

Does an audit automatically mean I owe more tax?

No. Some examinations conclude with no change to the return, while others result in adjustments favorable to the taxpayer.

Final Thoughts

Receiving an IRS audit notice can feel overwhelming, particularly if you have never been through the examination process before. Fortunately, the audit follows a structured process.

Understanding each stage — from the initial notice through document production, interviews, proposed findings, and Appeals — allows taxpayers to make informed decisions rather than reacting under pressure.

The objective should never be to “beat” the IRS. The objective is to ensure that the return is evaluated fairly, the facts are accurately presented, and the applicable tax law is applied correctly.

Need Professional Assistance?

If you have received an IRS audit notice — or simply want to better understand the examination process before responding — Boulanger CPA and Consulting PC can help you evaluate the issues, organize records, respond to IRS requests, and navigate the audit process from the initial notice through Appeals when necessary.