Why the IRS Doesn’t Need to Audit You to Drain Your Bank Account

If you fear a tax audit every time you file, here’s a fact that may help you breathe easy: The Internal Revenue Service (IRS) selects less than 1% of income tax returns for audit each year.

But what you may not know is that the IRS doesn’t need to audit you to hit you with extra taxes.

The agency’s computers automatically scan returns and match reported income against data from employers and banks. Those scanners tag anything that looks good.

If something goes wrong, you will get a letter. And while it’s not an audit, the result could be just as painful for your wallet.

The IRS knows more than you think

Every January, you receive dozens of income forms – such as W-2s from employers, 1099-INT forms for earned income and 1099 NECs for self-employment.

What you may not realize is that the IRS receives copies of all of these documents, usually before you file your return.

After you die, IRS computers compare what you reported on your tax return against what third parties say you earned. If there is a gap, your return is flagged. No personal review. There is no formal audit.

The system then generates a notice raising additional tax based on any income you failed to disclose.

Here are some common situations that may draw the attention of the IRS:

• Unreported 1099 income. Don’t forget the income from that freelance project you did or the interest from a high-yield savings account. If you received a 1099 and didn’t include that income, expect a notice.
• W-2 difference. Sometimes employers make mistakes, or you may have multiple jobs and miss reporting one. Either way, the computer catches it.

If your numbers don’t add up to what the IRS has on record, you may find yourself explaining why.

What happens when things don’t match

If the IRS notices a discrepancy, you will usually receive a notice proposing an adjustment. A proposed settlement explains what the IRS believes you owe and why.

These notices lay out the differences, show the IRS calculations and give you options. You can agree and pay or object and provide documentation that proves the IRS is wrong.

If you completely ignore the notice, the IRS can assess the additional tax without opening a formal audit. The agency does not need your agreement or participation to add charges to your account.

The true cost of taking a chance

Some taxpayers see the low level of audits as giving them room to push the limits. But automatic matching has changed the reality.

Consider failing to report self-employment income.

Even if you avoid a full audit, a tax return from the IRS rarely comes alone. By law, the agency charges interest on underpayments – currently 7% per year, compounded daily – which accrues automatically regardless of the reason for the error.

Costs increase significantly if the IRS believes you were at fault. For errors attributed to negligence or disregard for tax laws, you face a 20% accuracy-related penalty.

In the most severe cases where the agency establishes fraud, that penalty nearly quadruples to 75%.

Add to that the cost of hiring professional help to respond, the time spent gathering records and the stress of extended IRS communications. That “opportunity” starts to look expensive quickly.

How to protect yourself before you file

The good news? Most IRS notices are completely avoidable with some basic preparation.

• Check all documents. Before you submit your return, take a close look at all the income documents you received. If you received the form, so did the IRS. Enter everything.
• Keep records that support the deduction. If you’ve claimed business expenses, charitable contributions or other deductions, keep documentation that proves the amount and eligibility.
• Review past returns for consistency. Significant changes in income or deductions from year to year can draw attention. Make sure you can explain any important changes.

What to do when the notification arrives

Never ignore IRS letters. The deadlines for opposing the proposed changes are strict.

Read the notice carefully and see if it’s a misunderstanding that a short answer can resolve. If the IRS is right, agree immediately to stop additional penalties and interest from accruing.

In complex situations, consider getting professional help before responding. Providing too much information or incorrect documentation can sometimes create new problems.