EXPLAINED: IRS audits - debunking common myths

[Michael Plaks]

Myth 1. IRS audits are very common / IRA audits are so rare that you can forget about them

The latter was true during the recent Covid years. We recently had an under 1% audit rate. However, two things are good to remember. One is that all published rates represent all filed tax returns, including super simple returns of W2 workers without any business or investments. 

Business returns have always had a much higher rate. Returns with high deductions are higher yet. And returns with aggressive positions such as Real Estate Professional status or STR loophole are among the most frequently audited types of returns.

Second, our government tends to swing from one extreme to the other. Most of my colleagues expect audit rates to go from the lowest ever to the highest ever. Several signs point to this unpleasant trend already being in motion.

Do we expect the IRS to audit one out of 10 returns? Never, they don't have this kind of resources.

Myth 2. If the IRS audits you, you (or your CPA) have done something wrong on your taxes.

Let's review how tax returns are selected for an audit. First, the IRS computer assigns every tax return a number called DIFF score. It's similar to your credit score: add points for good behavior, subtract points for bad behavior.

Except the IRS criteria of good and bad behavior is a highly protected secret, and nobody really knows how this score is calculated. After years of observing what tax returns are being audited, we can make some good guesses. Based on our guesses, we tax pros advise our clients on minimizing their audit exposure. But it's still not based on hard evidence. 

After their computer flags returns with high enough DIFF scores, these returns are reviewed by an IRS employee. This employee decides whether your tax return looks suspicious enough to be audited. If you're lucky, they will ignore their computer recommendation and move on to their next victim.

Why then is this Myth 2 a myth? Because the process I just described is not the only way to get audited.

Some returns are selected under the IRS "related examination" program. Maybe YOU have not done anything wrong. But your business partner did. Or your tax preparer did. Or your employer did. And so on. Sometimes you're collateral damage of someone else's actions. For example, if you chose a crooked tax person whose promises were too good to be true but too enticing to resist, one day every one of their clients can get a dreaded IRS letter. Including you. 

Finally, some tax returns are being selected for an audit randomly. Yes, you read it right: completely random. Your SSN came up in the IRS sweepstakes lottery. Congratulations!

Bottom line: sometimes it's what you put on your tax return, and sometimes it isn't.

Myth 3. If you received your refund, the IRS has accepted your tax return, and you dodged the audit bullet.

No, they merely "processed" your tax return. The audit risk has not come into play yet.

Traditionally, audit letters start coming around 1.5 years after you filed your taxes. You just submitted your 2022 tax return at the end of 2023. Should you be targeted by an audit, when will you hear from the IRS? Probably some time in 2025. 

Prepare for a lot of sleepless nights until the storm cloud passes.

Myth 4. The worst that can happen is that I lose my aggressive deduction, and I have to pay the tax that I tried to avoid.

You will also be asked to pay interest and penalties. Interest goes back all the way to the date your taxes were due. Say your 2022 tax return is selected for an audit in the summer of 2025, and you conclude the audit process in the spring of 2026 with some extra taxes assessed against you. The interest will go all the way back to April 15th of 2023.

It's 3 years worth of interest. Considering that today's IRS interest rate is 8%, it is no small extra. If you owe $10,000 then this interest turns it into $12,400. Unlike with penalties, there is absolutely no way to remove or negotiate IRS interest, by law.

And speaking of penalties, every time you owe them $5,000 in extra taxes or you underreported 10% of your income - the IRS will add a 20% penalty to your balance. So now it's $14,500 instead of $10,000. Actually more, because interest is also accrued on penalties. A subtle way to increase the pile.

Also, never cross into the territory that the IRS may consider fraud. Such as claiming deductions that you KNEW were made-up or hiding your income. If the IRS can prove that you did it knowingly, you're looking at a minimum 75% penalty and possibly a referral for criminal investigation. No tax "savings" are worth this.

Myth 5. Without receipts, you automatically lose every deduction.

Fortunately, this is not the case. True, the IRS might attempt to disallow everything that you cannot prove with receipts. In fact, they are likely to attempt just that. However, there're other methods that you can use trying to defend your deductions.

No, I'm not talking about the often mentioned Cohan Rule. YouTube gurus have no idea what they are talking about when they assure you that you can simply mention "Cohan Rule" - and the IRS will suddenly recoil and allow all your deductions without a single receipt. This rule can indeed be used, but only in limited situations, only as your last resort, and only AFTER you established your credibility. Details are not for this post.

The methods I'm talking about involve convincing your IRS auditor that your numbers were honest and reliable by using other evidence, less convincing than receipts. Your books, your notes, your apps, using another year as a model, expert and non-expert testimonies, and so on.

None of that is easy to apply, and none of that is likely to protect 100% of your deductions. So, why make your future audit more difficult and more stressful than it has to be? Just keep the darn receipts. Electronic format is best - scan or photograph papers before they fade out. 

Myth 6. I don't need to keep any documentation after 3 years.

True, the standard IRS audit window is 3 years after your tax return is filed. However, there're exceptions. 

If you underreported 25% of your income, the IRS has 6 instead of 3 years to go after you. And if you never bothered to file your tax return for one of the years, the IRS has how long to look into this? Forever. Yes, forever.

How often does the IRS go back beyond 3 years? Very rarely, almost never. They don't like extra work, either. But they can, especially if you're either difficult to work with or your errors are big enough. Or you're running for President. So 6 years of receipts is safer than 3 years.

The most common error, however, has to do with properties you own. If you sell a property, you might need to prove how much you paid for this property originally, even if it was 20 years ago. Ditto for the improvements you made to this property 15, 10 or 5 years ago. All that documentation may be requested by your friendly IRS auditor. And if you already discarded it, she may become less friendly.

Moral: for all personal and (especially) investment properties - keep ALL receipts going all the way back to your original purchase for as long as you own it, plus for 3 years after the property is sold. And maybe even for 6 years after the sale.