The IRS conducts hundreds of thousands of audits a year, typically resulting in the taxpayer owing significantly more tax.   Most people shudder at the thought of having their tax return examined by an auditor and worry that they might not have sufficient records to defend it.  This article explores what might trigger an IRS audit and how far back the IRS can audit you.

IRS Audit Selection

The IRS audit process involves a review of the individual and/or business tax return(s) and supporting documents to confirm that the information has been reported correctly and that the tax due is accurate.

Most tax returns are selected at random for audit.  However, certain taxpayers have a higher a chance of getting audited than others.  There are several reasons why a tax return may be selected for examination, including the following:

• Taxpayer failed to report all taxable income: Any inconsistency between the information the IRS has on file and the information reported on the tax return can trigger an audit.
• Taxpayer is self-employed: Business income and expenses are reported on Schedule C of the individual income tax return. Arguably, there is more opportunity to hide income and commit tax fraud for self-employed filers.
• Taxpayer’s return reports a change in income as compared with prior filing years: Any large fluctuation, whether an increase or decrease, might trigger review.
• Taxpayer claimed a home office deduction: This deduction is only available to qualifying self-employed taxpayers and independent contractors and the rules regarding when you can claim it are strict.
• Taxpayer misrepresented the value of real property or assets which had the effect of reducing the tax owed.
• Taxpayer took excessive deductions: This can trigger review regardless of the kind of deduction (e.g., large charitable deduction, business deductions for meals, travel, and entertainment).
• Taxpayer claimed a hobby as a business: The time and money spent on the business must demonstrate an intent to become profitable, among other requirements.
• Taxpayer claimed 100% business use of a vehicle: It is unlikely that someone would use a personal vehicle for their business 100% of the time.
• Taxpayer or taxpayer’s accountant made errors on the tax return (whether clerical or mathematical) and/or failed to file all pertinent tax forms: The IRS has the authority to correct your tax return for you. Some errors and omissions will require a formal amendment.
• Taxpayer is in a higher income tax bracket: Taxpayers with income in excess of 10 million dollars have substantially higher audit rates.

While the above factors may trigger an audit, in recent years most taxpayers had a less than a 1% chance of getting audited.  Overall, IRS audits plunged by 44% between fiscal years 2014-2019.  However, as part of the Inflation Reduction Act that was recently passed, the IRS will receive 80 billion dollars in funding and plans to hire 87,000 new employees, many of whom will serve as auditors.

It is important to understand your potential audit exposure and the issues that might constitute red flags for the IRS.  Tax lawyers and accountants are accustomed to monitoring their clients’ audit exposure.  However, all taxpayers should have a general understanding of the statute of limitations in this regard.

How Far Back Can the IRS Audit You?

A statute of limitations is a time period established by law to review, analyze, and resolve taxpayer and/or IRS tax related issues.  The Internal Revenue Code proscribes specific timelines for IRS action, including how long the IRS has to assess additional tax via audit.  Generally, the IRS has either three years or six or forever, depending on the circumstances.

Audit Three-Year Statute of Limitations

Most audits only go back three years.  In this situation, the three years start to run from the date you filed your tax return.   You can’t shorten the three years by filing early.  If you file early, the three years will start to run from the date the tax return was due.  For example, if you filed your 2020 individual income tax return in February of 2021 when the deadline was April of 2021, the three years will start to run from the filing deadline in April of 2021.  It is the later of the actual fling date or the due date that triggers the statute.

If the audit is not concluded within the typical three-year timeframe, the IRS may request that the taxpayer consent to an extension of the statute of limitations.  The taxpayer is not required to do so and is encouraged to consult with their tax attorney in this situation.

Audit Six -Year Statute of Limitations

There are exceptions to the three-year rule that turn on unreported income.

If you omitted more than 25% of your income on a federal tax return the IRS will double the three=year period to six.  Note that you may be deemed to have unreported income if you overstate basis of property which has the effect of underreporting by more than 25%.

Also, if you omit more than $5,000 in foreign income, gifts and/or assets (e.g., offshore accounts) from your tax return, the three years is doubled to six.  This rule applies even if you disclose the existence of the account on your tax return and filed the requisite FBAR (Report of Foreign Bank and Financial Accounts).

Audit – No Time Limit

There are three situations where the IRS can audit you forever:

• You never filed a tax return: If you don’t file a return for a particular year, the statute of limitations for that year has not started to run. Until the tax return is filed, the IRS has unlimited time to audit.
• You filed a fraudulent tax return. Tax fraud amounts to the willful and material submission of false statements or false documents in connection with a tax return.  This could include claiming false deductions, claiming personal expenses as business expenses, and not reporting income.
• You omit certain tax forms: These include Form 5471 if you own part of a foreign corporation, Form 3520 for gifts or inheritance from foreign nationals, and Form 8938 for overseas assets. Foreign income from investments, gifts, inheritances, and other assets must be claimed on your tax return with the appropriate forms.

Collection Statute of Limitations

The above statue govern how long the IRS has to conduct an audit and assess additional tax for a given tax year.  There is also a collections statute of limitations, governing how long the IRS has to collect taxes from the taxpayer, which is typically ten years.

In summary, the IRS has a minimum of three years to make adjustments to your tax return and assess additional tax – and in some cases six years or an unlimited amount of time.  Once the tax has been assessed, the IRS has ten years to collect it.

Do You Need a Tax Attorney?

It is advisable to consult with a tax attorney to help you determine which statute of limitations apply to you, explore whether you might be at risk of an audit, and obtain guidance on how to minimize audit exposure.  If your tax return is selected for an audit, a competent tax attorney can provide counsel regarding the information and documentation that will be necessary to successfully defend your tax return and can help you avoid the assessment of additional tax, interest, and penalties.

The experienced attorneys at Segal, Cohen & Landis understand the laws and regulations set forth in the Internal Revenue Code and the Internal Revenue Manual.  We have successfully resolved thousands of audit cases for clients involving a wide range of examination issues.  We help our clients:

• Communicate with the IRS and assigned auditors throughout the entire examination process.
• Present the supporting documentation with a view to best defend your tax return.
• Defend the items reported on your tax return and minimize the assessment of additional tax.
• Resolve any outstanding liability on appeal, including abatement of penalties wherever possible.
• Avoid future tax audits of the same issue(s).

We also note that the attorney-client privilege protects all communication between Segal, Cohen & Landis attorneys and their clients, such that any and all information discussed and exchanged shall remain confidential and private.

If you are interested in having a complimentary consultation with one of our partner attorneys regarding your tax matter, please feel free to contact us.  We would be happy to speak with you and will advise you as to how we can resolve your case and how much it would cost.