Mark Hauser Explains How an IRS Audit Works and Provides Useful Audit Preparation Tips

Mark Hauser, co-managing partner at Hauser Private Equity, highlights the IRS audit process and gives tips for preparing for an audit.


Receiving an Internal Revenue Service (or IRS) audit notice can instill uncertainty in even the most level-headed adults. Even taxpayers who believe they have closely adhered to the official tax guidelines will be nervous. However, private equity expert Mark Hauser notes that with well-organized documentation and optional professional representation, the taxpayer is well-positioned to state their case.

Why the IRS Performs Tax Audits

The Internal Revenue Service has created its own definition of an IRS audit. “An IRS audit is a review/examination of an organization’s or individual’s accounts and financial information to ensure information is reported correctly according to the tax laws and to verify the reported amount of tax is correct,” notes the IRS website.

Stated another way, the IRS executes audits to reduce the “tax gap.” This is the difference between the money the agency receives and the amount it’s owed from taxpayers. 

Sometimes, the agency randomly chooses a tax return to audit. On other occasions, a taxpayer is audited because they conducted business with an individual currently involved in an audit. Examples include executing financial transactions with an investment partner or business partner.

7 Risk Factors That Can Trigger a Tax Audit

The IRS frequently audits tax returns that appear to contain unusual or suspicious activity. Mark Hauser says seven identifiable risk factors increase a taxpayer’s chances of receiving a tax audit letter.

Failure to Report Income

Taxpayers who earn non-wage income must report these earnings on their tax returns. Known as Form 1099 income, this includes freelancing payments, interest, and stock dividends. The IRS may soon require taxpayers to report non-wage income from other sources as well. 

If the income is received from a company or institution, that entity also reports that taxpayer’s earnings to the IRS. If the taxpayer doesn’t report this non-wage income, they’re likely to be tapped for an audit.

Excessive Business Expenses

A taxpayer’s business expense deductions must be customary for that business or industry. The deductions must also be essential to the business’ operation. If both of these conditions aren’t met, the taxpayer faces an increased audit risk.

To illustrate, the owner of a casual dining restaurant could have his tax return flagged for his suits’ dry cleaning expenses. The dry cleaning costs don’t meet either deduction requirement.

A Home Office Deduction

Many taxpayers are tempted to take a home office deduction that can potentially decrease their taxable income. However, the IRS has strict rules for this popular deduction.

In the agency’s own words, this deduction is meant for taxpayers who use a portion of their home “exclusively and regularly for your trade or business.” If the taxpayer can prove they have a dedicated workspace not used for another purpose, they have a stronger chance of proving their case.

Too Many Schedule C Losses

Self-employed taxpayers may think it’s acceptable to list personal expenses as business expenses. Not surprisingly, this lowers the business’ taxable income and could result in an operating loss.

However, Mark Hauser says the IRS will notice this unusually high number of reported Schedule C losses. From this perspective, the agency may wonder how the owner can continue to stay in business. Therefore, the IRS will likely audit the owner’s (or business’) tax return to find out.

Unusually High Charitable Donations

Taxpayers who make substantial charitable contributions could receive some welcome tax deductions (depending on their tax situation). However, they should ensure that they have credible documentation for each contribution. The IRS will notice donation amounts incongruent with the taxpayer’s income level and/or previous donation practices.

Incorrect Number-Rounding Methods

Tax documents rarely list nicely rounded numbers. Therefore, when calculating taxes, taxpayers should always round amounts to the nearest dollar, not the nearest hundred dollars. The latter practice is likely to raise an IRS red flag and potentially trigger an audit.

Careless Mathematical Errors

The IRS won’t appreciate a taxpayer’s simple math errors, such as transposing numbers or neglecting to add a zero (or two). To avoid careless errors that could lead to an audit, taxpayers should check their calculations at least twice. Using good tax preparation software, or working with a professional tax preparer, can help avoid these mistakes that could result in an audit.

Typical Audit Timeframes

Private equity expert Mark Hauser notes that when choosing an audit candidate, the IRS typically selects tax returns filed within the past two years. If a significant error appears to have occurred, the agency may add older returns to the audit. However, it’s rare that the IRS audits a tax return more than six years old.

Extending the Statute of Limitations

If the audit isn’t satisfactorily resolved, the IRS may request to extend the three-year statute of limitations for tax audits. This enables the agency to further investigate and assess additional tax or make a refund.

By extending the statute of limitations, the taxpayer has additional time to send necessary documentation that supports their case. They can also use the extra time to claim a credit or refund. If they disagree with the audit outcome, they can file an appeal.

Experienced advisor Mark Hauser emphasizes that the taxpayer does not have to agree to the statute of limitations extension. If they don’t agree, however, the auditor must decide the case based on the information available to them at the time.

How an IRS Audit Works

Breaking down an IRS audit may make it seem less intimidating. The process begins when the IRS contacts the taxpayer (usually via a mailed letter). The IRS will spell out the area(s) to be audited and request certain documents the agency’s representative wants to examine.

The IRS will also indicate whether the representative will conduct the audit by mail. Other audit venues include an IRS office, the taxpayer’s home or business premises, or an accountant’s office.

The taxpayer has 30 days to respond to the initial audit letter. Private equity investor Mark Hauser recommends that the recipient respond immediately, as interest continues to accrue on any amounts owed to the IRS.

Getting Ready for an IRS Audit  

An IRS audit isn’t to be taken lightly. Well before the scheduled audit date, the taxpayer should determine whether they want professional representation.

An attorney, a Certified Public Accountant (or CPA), an IRS Enrolled Agent, or a paid tax preparer can accompany the taxpayer. Alternatively, this professional can attend the audit instead of the taxpayer. Either way, there will likely be a substantial fee for this service.

The audit’s length depends on several factors. The audit’s type and complexity, the availability of requested documentation, and both parties’ availability for meetings, are contributing factors. The taxpayer’s agreement (or disagreement) with the audit’s findings also helps to determine the process’ duration. 

Documents Commonly Required for an Audit

First, the taxpayer should assemble the documents the IRS has requested. By law, notes Mark Hauser, taxpayers should keep all tax return documentation for at least three years from the return’s filing date.

The taxpayer should bring copies (not originals) to the audit. In addition, the taxpayer should ensure the documents pertain to the tax year under question. Although everyone’s situation is different, here’s a sampling of documents often required for audits:

  • Employment Pay Stubs
  • Purchase Receipts
  • Financial Transaction Records
  • Home Mortgage Statements
  • Brokerage Account Statements
  • Retirement Account Statements
  • Previous Years’ Tax Returns

A Well-Defined Audit Process

During the IRS audit, the taxpayer should remain polite and provide documentation as requested. However, the taxpayer should not volunteer any unsolicited documents and/or information. With that said, the IRS has spelled out specific taxpayer rights during a tax audit:

  • The right to representation, whether self-representation or by an authorized professional representative
  • The right to know why the IRS wants certain information, how they will use it, and the consequences for not providing this information
  • The right to courteous, professional treatment from IRS representatives
  • The right to privacy and confidentiality regarding all tax issues
  • The right to appeal tax-related disagreements within the IRS and before a court of law 

3 Potential Outcomes of an IRS Audit

After the audit concludes, and the IRS representative reviews all relevant documentation, they will issue their decision. Mark Hauser outlines three possible audit outcomes.

  • No changes to the return: The taxpayer has provided sufficient documentation to verify all reported claims. No further action is needed.
  • Changes with agreement: The IRS proposed changes, and the taxpayer understands and agrees with them. The taxpayer signs an appropriate form and arranges for payment of additional tax due (if applicable).
  • Changes with no agreement: The IRS proposed changes, and the taxpayer understands but disagrees with them. Now, the taxpayer can take advantage of mediation, meet with an IRS manager, or file an appeal if there’s sufficient time left on the statute of limitations.

Good Preparation is Key

Although undergoing an IRS audit can be a nerve-wracking experience, a taxpayer’s good organizational skills can help them prepare for the process. With accurate documentation, a cooperative attitude, and perhaps professional representation, Mark Hauser emphasizes that the taxpayer is well prepared for any outcome.

Interesting Related Article: “How taxes affect different types of businesses