5 Problems With A Federal Income Tax Audit

Federal Income Tax Audit – What does it mean to get audited?

My 2016 Federal tax return was recently audited by the IRS, and I can’t say that I liked it.  Well, that’s pretty obvious, isn’t it?  After all, when it comes to audits, what’s to like?  But aside from the obvious displeasure I had in getting audited in the first place, what problems did I encounter, and what does that mean to you?

Before I answer those questions, let me first clarify what it means to get audited.  Does it mean a pair of men in dark suits, sunglasses, and those little ear devices show up at your doorstep in the middle of the night, or does it mean to be summoned to the nearest IRS office?  While the latter is still a possibility, that’s really not how most audits happen these days.  Instead most audits now are “correspondence audits” (otherwise known as “desk audits”), or a letter in the mail from the IRS stating that they disagree with a specific part of your return, informing you of a corresponding adjustment (which increases your tax bill or decreases your refund), and providing you with information enabling you to contact them if you disagree with the adjustment.  And it’s this kind of audit – a correspondence audit – that I was subjected to. And again, aside from having to devote time and energy to dealing with an audit in the first place, I had 5 problems with the process.

Problem #1 – The IRS will automatically reduce your refund

After completing and filing my 2016 Federal tax return I was due a refund of $1,250, which I requested to be deposited electronically in my bank account.[1]  As a result, you can imagine my disappointment when I only saw a refund of $750 hit my bank account, a full $500 less than I was expecting.  I got out a copy of my tax return and flipped through it.  As far as I could tell, everything looked correct.  And yet there I was, with $500 less than I was expecting.  To make matters worse, because the IRS already had my money I was now forced to deal with their bureaucratic machinery if I wanted it back.  Said another way, if I took no action then my $500 was gone forever.

This situation illustrates an important financial principle.  Whenever you’re in any kind of financial dispute, you want to be the one holding the money if at all possible.  What does that mean as far as filing your tax return goes?  Everyone, it seems, loves a tax refund.  And I admit, it’s nice to get that refund check in the mail (or electronically deposited as the case may be), but it’s really not the ideal tax filing strategy.  The reason is if the IRS calculates a different tax liability than you then they’ll automatically reduce your refund, and the impetus will then be on you to get your money back.  As a result, the sweet spot is to owe $1 upon filing your federal tax return.  Why?  Because the out-of-pocket cost of filing your tax return is low (meaning you just have to send it in with a check of $1 rather than having to suddenly and unexpectedly come up with $1,000) and, if the IRS disagrees with your tax calculation, then they’ll have to bill you.  That wouldn’t be good news, of course, but at least you would still be holding on to your money as you worked things out with the IRS.

Problem #2 – The reasons the IRS provides for reducing your refund can be VERY vague

Naturally I wanted to know why I got less of a refund that I expected.  With no correspondence from the IRS yet (remember, at first I only saw that less hit my bank account than I expected), I went to the IRS website (www.irs.gov) and clicked on “Where’s My Refund” to find out more specific information on what was going on.

What a disappointment.  Instead of seeing a line-by-line comparison along the lines of, “Here was your tax calculation, here is where our tax calculation was different, and this is the difference,” the only information that was given was a vague statement that the adjustment was related to “Self-Employment Tax.”  Once again I looked at a copy of my 2016 Federal tax return, this time focusing on the self-employment tax-related sections, and I still didn’t notice any errors.  A bit frustrated at this point, I now realized that I had to wait on a formal correspondence letter from the IRS that would provide more details.

When the letter finally did come it was also a disappointment, telling me little more than the information I had gotten from the IRS’s website.  The one page letter said, “We believe there’s a miscalculation on your 2016 Form 1040, which affects the following area of your return: Self-Employment Tax.  We made changes to your return that correct this error.  As a result, you are due a refund of $750 (again, $500 less than the $1,250 that I was expecting).”  There was a little more information in a section titled, “Your tax calculations,” but it was just top-level information from Form 1040.  In summary, given the fact that the IRS clearly performed a specific calculation to come up with an adjusted refund amount for me ($500 less than I was expecting), it was disappointing that that they didn’t give me enough information on what they had done to clearly understand what was going on.

Problem #3 – You’ll be the one that has to do the heavy lifting

Since it was obvious that no more information from the IRS was forthcoming, I had no choice (if I wanted my $500 back) but to roll up my sleeves and get to the bottom of things.  When I finally got a block of time (something which doesn’t always come easy for a regular person), I used the information on my tax return and my supporting documentation to build a spreadsheet analysis of the IRS’s adjustment.  My objective was to figure out what calculations the IRS used to arrive at my adjusted refund.  Once I knew that, I could make a judgment on whether they were correct or whether my tax return as originally filed was correct.  After about an hour and a half or two of sustained effort I finally determined how the IRS arrived at their adjustment, and when I compared it to my own figures it was clear to me that I had been right all along.  While that was good news, I didn’t exactly feel like celebrating.  After all, I had already put in a good deal of time, focus, and energy into determining what was going on, but I still had to deal with the IRS directly in order to get the remaining portion of my refund back, and that’s something that can be difficult and time-consuming as well.

Problem #4 – You’ll be at the mercy of the IRS in getting in touch with someone who can help you

In responding to the IRS I essentially had 2 options.  I could write them or I could call them (both an address and a phone number were provided for in their correspondence audit letter, otherwise known among tax professionals as an “IRS notice”).  After giving it some thought I decided to call.  Why?  First of all, I had done my calculations, so I knew exactly what the problem was and what the IRS needed to do to fix it.  Second, since that was the case, I knew that if I got the right person on the phone then I could get my issue resolved in short order.  Finally, I figured that if a phone call didn’t work the way that I hoped it would then I could always send a formal letter to the IRS using the address that they provided.

I was fortunate when I called that I got an IRS employee who was reasonable, helpful, knowledgeable and responsive.  I explained my issue to her and she listened to what was going on, giving me the benefit of the doubt.  To some degree I believe her attitude had to do with the fact that I was prepared and knew exactly what I was talking about, and I was careful not to complain.  In any case, shortly into our conversation she asked me to fax her my tax calculations, which I did.  Upon examining them she agreed the problem was on the IRS’s side and, after further investigation, she realized it was because an IRS employee had incorrectly keyed my return into the system.  As a result, she agreed right then and there that my return was correct as originally filed, and she authorized the remaining portion of my refund ($500) to be wired to my bank account within a few business days.  And, fortunately, that is indeed what happened.

As you can see, while my audit took some time and effort to resolve (even though I was right all along), it did end up working out without an excessive degree of difficulty.  However, an important factor in things going as smoothly as they did was because I was fortunate to have gotten ahold of someone at the IRS who was both competent and helpful.  While that is often the case, sometimes it is not.  The IRS is a huge, bureaucratic government agency, and unfortunately I’ve run into some hardheads over time.  When that happens – even if you’ve got your ducks in a row – it can be tough sledding.  And if that happens then what do you do?  Well, that’s when things get hard, because you have to either keep dealing with a difficult person, call back and try to get someone else, or respond in writing.  With any of those choices the resolution of your situation can stall as you find yourself getting stuck in the bureaucratic mire of the IRS.

Problem #5 – It’s unlikely that “regular people” will be able to resolve many tax problems on their own

Look, I’m a regular person in many ways.  I can’t tell what that rattle in the car means, I don’t know why my rose bush is dying, and when my TV remote starts acting weird I don’t really know what to do.  But when it comes to income taxes (and personal finance in general) then I’m in my element; that’s what I do, and that’s what I’m good at.  So even though things worked out well for me as far as my audit was concerned, as I said above, I think in large part it had to do with the fact that I’m a tax professional who knows my way around the system.  In short, I don’t think a “regular person” (as far as taxes goes) could have resolved an audit similar to mine, at least not without a lot more time, pain, and/or expense.  And specifically what would a regular person’s options have been in a situation similar to mine?  Here they are, and none of them are attractive.

1. Spend lots of time – The first option would have been to spend substantially more time than I did (remember, I’m a tax professional).  But unfortunately time alone is not enough to resolve your tax problems if you don’t really know what you’re doing any more than I can make my TV remote work without understanding the technology behind it.
2. Spend lots of money – Another alternative would be to hire a tax professional to help you, but that could cost you anywhere from $75 to $200 an hour.  As a result, you could lose a massive chunk of your refund before you ever see any money…and that’s if you’re right in the first place!  If you’re tax return turned out to be wrong then you will get hit with the double-whammy of by spending money on professional fees only to confirm that you do indeed owe the IRS more money.
3. Do nothing – Finally, if dealing with the IRS seems like it’s going to be too expensive, bewildering, and/or intimidating relative to the time and/or money you would have to put into it then the final option would be to just eat the $500 assessment and write it off to bad luck.

In summary, while I won’t be happy about it, you can drop a tax professional like me in the middle of an IRS-created wilderness with very little to go on and I’ll find my way out.  But unless the IRS does a better job of providing clearer, more understandable guidance in their correspondence audits then regular people stand to lose a lot of money, either in tax assessments or professional fees.  And that’s precisely the kind of time-consuming, stressful, unexpected, and expensive situation that regular people need all the help they can get as they deal with all of the other pressures of day-to-day life.

What is the solution to successfully dealing with IRS audits?

Given the significant problems you can encounter with an IRS audit, what should you do?  There are no easy answers, but you basically have two alternatives.  First, you can have your tax return prepared by a competent tax professional who will stand behind their work in the event that you are audited.  Second, you can roll up your sleeves, learn how to deal with your own tax situation, and then take care of your problems yourself.

I believe the latter – tax self-sufficiency – is the best route to take.  Taxes can be a significant expense, so it’s unwise to be totally unaware of how they’re calculated if you can at all help it (register with this website or like it on Facebook for more guidance from future articles!).  Finally, even if you find you cannot handle a certain tax issue yourself, the efforts you do make to understand it will almost certainly pay off since it will better enable you to make informed decisions based on the guidance of your tax advisor.