Our Bright!Tax IRS Insights series lifts up the hood to reveal the inner workings of the IRS engine. Today we'll be looking at the best strategies for responding to an IRS audit letter.
As described in our previous IRS Insights article, the IRS can access a vast amount of information about US taxpayers living abroad, including account info from foreign banks, credit card and international travel expenditure, and foreign tax records.
A much higher proportion of Americans living abroad were audited last year than Americans living in the US – 4.3% of international returns were audited compared to just 0.8% of 'domestic' returns. This illustrates that as an expat the audit risk is significantly higher.
The IRS typically has three years from a tax return date due or filing date (whichever is later) to audit a return. An exception to this rule is when income has been “substantially under-reported,” meaning you omitted at least 25% of your income from your return, or $5,000 of foreign income. Then the IRS has six years in which it can audit; or, if no return has been filed at all there's no time limit.
The typical time between when a return is submitted and an audit letter is sent out is two years. As such, it's important to keep all your records relating to your foreign income, taxes and expenditures for at least three years.
The most important point to make is that if you are honest and accurate when filing, you are unlikely to be audited, and even if you are, so long as you have kept all your tax and income records, an audit is nothing to be afraid of. If your situation is complex, or you have any doubts about your ability to file a full and accurate return though, seek help with your filing from an expat tax specialist. This will ensure that what might be an honest error isn't misinterpreted as tax evasion if you are audited later on.
If the IRS does decide to audit you, they will send you a letter. If you receive an audit request by email or by phone, do not respond, as it's likely a fraud attempt.
When deciding whom to audit, the IRS looks for certain 'red flags'. These include:
- Income reported on a return doesn't match info provided by other sources (foreign banks, foreign tax records, etc)
- Higher than average deductions
- Small businesses reporting consistent losses over multiple years
- Large charitable contributions relative to income
- Complex business or investment transactions
- An early payout from a retirement plan
- Failing to report gambling winnings
- Failing to report a foreign bank account
The first and last of these are particularly relevant for expats. If you have a total of at least $10,000 in one or more foreign financial accounts at any time during the tax year, you are required to file a Foreign Bank Account Report (also known as an FBAR, or FINcen form 114) online by June 30th.
If you receive an audit letter, first of all, don't panic: most audits are simply seeking clarification or back-up documentation that you probably already have.
Bright!Tax currently employs former IRS International Tax Auditors with first hand experience of current IRS best practices, so Bright!Tax is uniquely positioned to offer IRS insider strategies and insights.
The IRS is required to tell you why your return was selected for audit. If this isn't clear in the audit notice, your first task is to ask, as knowing will allow you to focus on gathering the relevant documents. Reasons for an audit may include something on your return not matching other IRS records, a transaction with somebody else being audited, that one of the above list of 'red flags' was triggered, or you may have just been selected at random.
Your second task is to find out what type of audit it is: a Correspondence Audit, an Office Audit (where you must appear in person at an IRS office), a Field Audit (where the IRS visits you), or a Taxpayer Compliance Measurement Program Audit, which is the most extensive type of audit. If it is a Field or TCMP Audit, it may be helpful to have a tax lawyer present when the audit is conducted.
Once you know what is expected of you, you can prepare your supporting information. If you need more time to do this, you can request a postponement.
Whenever dealing with the IRS, whether by correspondence or in person, be honest, accurate, courteous, and polite, and be sure to respond to the IRS within any deadlines they set. So long as you prepare carefully and accurately, it's more than likely that the outcome with be positive.
Once you know why you are being audited and what info you are required to provide, if you feel that you can't address the issues raised on your own, consult a tax specialist or lawyer at the earliest opportunity.