An Internal Revenue Service audit involves a review of a taxpayer’s return to determine if the information is correct, both mathematically and in terms of the actual income and expenses that the taxpayer experienced that year. When the IRS does an audit, they will request specific supporting documents and information related to a taxpayer’s finances. In many situations, it may not be entirely clear why the IRS is conducting a tax audit of a particular taxpayer. To understand what the IRS is trying to find, it might be helpful to understand the answer to the question: Why does the IRS audit tax returns? Damiens Law can often help answer this question for specific taxpayers. Our dedicated legal team may be able to review your situation to help you understand why the IRS might be interested in your specific financial situation. Call our Mississippi office at (601) 957-9672 or our Tennessee office (901) 499-4466 for more information.
Understanding the “Tax Gap” and IRS Audits
The “tax gap” refers to the amount that the IRS is owed from a taxpayer and the amount the IRS actually receives on time. The tax gap can be enormous—the IRS estimated that from 2014 to 2016, the tax gap was $496 billion. The tax gap is generally made up of the following three pieces.
- Nonfiling gap
- Underreporting gap
- Underpayment (or remittance) gap
The tax gap can arise when taxpayers fall behind on taxes owed. However, the tax gap also appears when taxpayers incorrectly calculate the tax payment they must make to the IRS. This incorrect amount might result from inadvertence or mistake, or it could be deliberate underreporting of income or overreporting of expenses.
Ultimately, the IRS conducts an audit to decrease the effect of the tax gap. By decreasing the tax gap, the IRS can work toward complete compliance with tax laws and regulations. By ensuring that each taxpayer pays as much as they should, the IRS makes the application of tax laws and regulations a bit fairer among taxpayers.
Occasionally, tax audits are random. The IRS might pick and choose returns based on random selection after they go through a screening process. In other situations, the IRS conducts an audit because the screening process found a deviation indicating some suspicious activity. Arguably, the IRS is not interested in overcharging taxpayers, however, they are interested in ensuring that each taxpayer pays their fair share of taxes as required by law.
What Circumstances Might Trigger a Tax Audit?
Audits can be random, but the IRS often starts an audit because it sees a red flag. A red flag might not mean a deliberate attempt to avoid paying taxes, but it could be a sign of an error. Some of the most common red flags or signs of suspicious activity are included below. These common circumstances may answer the question: Why does the IRS audit tax returns?
Math errors are often the result of a simple mistake, but even innocent mistakes need to be addressed when they affect the amount of taxes someone needs to pay. Math errors might be simple typos, but they can trigger an extensive audit that is time-consuming and burdensome. As taxpayers work through their taxes, double-check all of your numbers before signing off on any tax return. Catching mistakes now can save a lot of time and headaches in the future.
The most common math errors include:
- Entering incorrect information from tax forms like W-2s and 1099s
- Using the wrong formula to calculate tax obligations
In 2020 alone, the IRS found more than 12 million mistakes that triggered notifications. Not all of these notifications lead to audits, but if there is an error, the IRS is more likely to take a closer look at all the tax return information. An error notification will likely come along with a proposed solution to the problem, such as correcting an obvious error or rerunning a calculation.
In some situations, mistakes can result in IRS fines and penalties, especially if the tax owed was not paid on time. Having a tax preparer help with the return or using tax preparation software can help decrease common math errors. The experienced tax attorneys at Damiens Law can provide resources for tax planning and tax preparation services in addition to addressing audits and record requests.
Taking Certain Tax Credits
Certain tax credits will grab the IRS’s attention. The most common credits associated with audits include:
- Earned Income Tax Credit
- Child Tax Credit
- American Opportunity Tax Credit
Some credits in 2021 were provided to taxpayers in advance rather than at tax time, which increased the complexity of these credits, including the Child Tax Credit.
When the IRS reviews tax credits, it reviews the specific amount claimed for the credit. It will also examine whether the taxpayer qualifies for the credit. Each credit has different requirements, so it is easy to assume that a taxpayer qualifies when they actually do not. Documentation for each credit is vital to prove that a taxpayer is entitled to take the credit.
Misreporting Taxable Income
For most taxpayers, reportable income comes in several forms, such as a W-2, Form 1099, or K-1. If the number that the business reported to the IRS does not match a taxpayer’s reported income, that can cause a problem. In many situations, the error can be corrected with a simple notification, but an underreporting problem can trigger fines and penalties. It might also cause the IRS to do a full, manual review of the return, which might lead to other problems.
Taxpayers should ensure they have all the forms they were expecting before filing their taxes. Most income forms, including W-2s and 1099, must be sent to taxpayers by January 31. However, other forms might be delivered later. For instance, K-1s are generally not ready to send to individual partners until after the Partnership filing date in mid-March.
The IRS is also providing additional insight and tips for “gig workers.” Some taxpayers who engage in “side hustles” or gig work are not accurately reporting their income, or they are not reporting income at all. The IRS has recently issued information for gig workers, reminding them that “gig economy income is taxable.”
Large Charitable Deductions
Large charitable deductions can be a red flag for the IRS. The IRS knows the average charitable donations for households of similar sizes to each taxpayer, so they can also tell when something is higher than it should be.
In addition, donated items can signal a problem, especially if the taxpayer did not get an appraisal for the property before the donation. Further, charitable donations on behalf of businesses can also raise alarm bells.
While charitable contributions should often be commended, they are occasionally used to avoid tax payments. Taxpayers should ensure that they keep receipts for all charitable giving, regardless of its form.
IRS Audit Funding for 2022 and 2023
The Inflation Reduction Act of 2022, which was passed on August 12, 2022, provided an additional nearly $80 billion to fund the IRS. According to the Congressional Research Service, those funds were allocated among several categories, including:
- Operations support
- Taxpayer services
- Business systems modernization
The vast majority of the funds were allocated to enforcement costs. The IRS reports that enforcement funds will be used to hire more enforcement agents, pay for litigation and criminal investigation expenses, and invest in investigative technology. The IRS states that investigations and audits will focus on taxpayers who make at least $400,000 and above, but audits are not expected to rise immediately.
As of January 9, 2023, however, a bill was before the House of Representatives that would rescind approximately $70 billion of the roughly $80 billion allocated to the IRS. The Congressional Budget Office (CBO) has raised concerns that such a budget cut would encourage tax cheating, expand the tax gap, and increase the federal deficit by more than $100 billion over the next ten years. Nonetheless, the House passed the funding slash on January 10, 2023. At this point, it is unclear whether this bill will move forward through the Senate. Moving forward, funds that the IRS thought would be available to increase audit activity may not be accessible.
Ensure Your Legal Rights Are Protected During Your IRS Tax Audit
Why does the IRS audit tax returns? To ensure that taxpayers are not overstepping tax deductions and credits and claiming all of their taxable income. IRS audits do not necessarily target only those who are deliberately attempting to deceive the IRS. They may audit innocent taxpayers who made a mistake or fall outside the IRS’s reported norms. No matter your situation, getting legal help with a tax audit can be very beneficial. Consider contacting the experienced tax attorneys at Damiens Law for help with your tax audit situation. Start by calling our Mississippi office at (601) 957-9672 or our Tennessee office (901) 499-4466 for more information.