Failed an IRS Tax Audit? What to Do

failed irs tax audit

Facing a tax audit of any kind can be daunting. IRS tax audits can lead to financial and even legal consequences that you want to avoid. The audit process will depend on the type of issue you’re dealing with, your tax liability, your income level, and even your tax compliance history. These factors may also influence the outcome of the audit.

Many people fear that they will “fail” an audit, which usually means the IRS ends up finding a problem that leads to a penalty or other consequences. Not all audits have ideal outcomes for the taxpayer, but the goal is to take all possible steps to prevent and fully comply with audits.

So what happens if you get audited and fail? This guide covers everything you need to know about failing a tax audit, how audits usually work, types of relief, and IRS audit penalties.

What Causes a Tax Audit?

Many factors may trigger a tax audit, even just random selection. The IRS states that being selected doesn’t always indicate that you did something wrong. Their formula may randomly select your return for screening.

Other triggers may include claiming a large number of deductions, claiming the home office deduction, showing major changes to your income from one year to the next, or reporting extreme expenses. The IRS may audit you if you underreported your income, which they can track based on documents received from entities that compensate you.

In addition, a mathematical error you make on your return could lead to an audit. This is why it’s crucial to only provide accurate information to the IRS.

An Overview of the Audit Process

The IRS always notifies taxpayers of audits through the regular mail. Your notice will let you know what type of audit you’re facing, which will be conducted either by mail or through an in-person interview.

In-person IRS audits may take place at:

  • Your home
  • Your business
  • An IRS office
  • An accountant’s/attorney’s office

Closely follow all instructions included on your notice. Mail-based audits will likely request that you send the IRS additional documentation about the details on your tax return, including financial information, proof of expenses, or deduction clarification.

Even though the chance you will be audited is small, the IRS asks taxpayers to keep all applicable documents for at least three years after filing their tax returns. During an audit, if you have an overwhelming amount of documentation to send the IRS, you can always request an in-person audit.

Types of Documents Requested During Audits

Types of documents the IRS may ask for in audits include these examples:

  • Bills
  • Receipts
  • Loan documents
  • Canceled checks
  • Legal agreements
  • Financial or travel logs
  • Medical records
  • Employment documents

Be prepared to provide documentation to back up anything you included on your tax return, whether related to your income for the year or deductions you claimed. In some cases, the IRS may ask for information that is not necessarily financial. For instance, if the IRS wants to verify your right to claim a certain dependent, the agency may request the dependent’s Social Security number or birth certificate.

When you’re not sure how to proceed with an audit, work with a tax professional for guidance. Some audits will be more complicated than others. If you’re unable to comply with the audit by the deadline provided, you may usually request an extension of 30 days. Use the contact information provided on your audit notice.

What Is an Underreporter Inquiry?

An underreported inquiry is slightly different than an audit. In this case, you will receive Notice CP2000 from the IRS, which indicates that the agency found a discrepancy between what you reported for income and what the IRS received about your income from other parties, like your employer, clients, or bank.

Discrepancies may be found with the IRS’s Automated Underreported (AUR) tool, which automatically compares income information. An examiner will then review the findings and send you Notice CP2000 if there is an actual discrepancy. This notice proposes an income adjustment, which could result in you paying additional tax or getting an additional refund.

How Long Will an IRS Audit Take?

Because there are many different reasons for tax audits, and taxpayers have widely different financial situations, the length of an audit will vary. Sometimes it only takes one set of correspondence in the mail to resolve it, while other instances may take weeks or months.

The IRS outlines these factors that determine the length of an audit:

  • The type of audit
  • The complexity of your tax issues
  • Whether the requested information is available
  • When the parties are available for meetings
  • Whether or not you agree with the audit’s findings

If you don’t agree with the audit’s outcome, you have the right to appeal. This could be the right option if the IRS made a mistake, the agency didn’t apply the law properly, you disagree with the action they’re taking against you, or the IRS is using incorrect facts. Appeals will lengthen the audit process.

Possible Outcomes of a Tax Audit

Each tax audit has three potential outcomes, as outlined by the IRS:

  • No change: This may occur when you have provided all requested information, and there is no change to be made after IRS review.
  • Agreed: This situation occurs when the IRS proposes changes based on the information provided, and you agree with their proposed changes.
  • Disagreed: This happens when the IRS proposes changes but you disagree with their conclusions.

Again, you may be able to appeal when you disagree with the agency’s findings.

But what happens if you are audited and found guilty? Maybe after providing all of your information to the IRS, the agency finds that you made a mistake, whether willfully or not.

What happens next will depend on the severity and manner of the issue. In some cases, you may not even have any documentation to back up your claims if they were false. You could then face a bigger tax bill, penalties, or even legal action.

Types of Tax Audit Penalties

Again, what happens if you fail an IRS audit depends on your specific situation. However, many taxpayers have to pay IRS audit penalties if they made some kind of tax return mistake. Here are common types of penalties that apply after a failed audit:

Accuracy-Related Penalty

This tax penalty applies if you don’t pay all the tax you owe. This commonly happens if you don’t report all your income for the year or you try to take deductions or credits that you’re not eligible for. There are two types of accuracy-related penalties:

  • Negligence or disregard of the rules or regulations: If you failed to make a “reasonable attempt” to follow all applicable tax laws when filing your tax return, or you carelessly, recklessly, or intentionally did not comply, you may face this penalty.
  • Substantial understatement of income: You may receive this penalty if you understated your tax liability by 10% of what was required on your tax return, or by $5,000, whichever is more.

The IRS will mail you a notice about this type of penalty. Accuracy-related penalties will be 20% of the amount of underpayment, whether due to negligence, disregard, or income understatement.

Important note: If you’re able to prove to the IRS that you acted in good faith and that you have a reasonable cause for failure to comply, you could receive a reduced penalty or have it removed. You can also follow the instructions on your notice if you disagree with the penalty.

Civil versus Criminal Penalties

Most tax-related penalties are civil penalties, meaning you don’t face any criminal charges for them. In cases of fraud, the civil penalty can be up to 75% of the unpaid tax.

Criminal penalties are more serious. You may face criminal charges if you were found to have taken part in tax fraud or tax evasion. Criminal penalties could be up to $25,000 in fines and/or one year of jail time if you are found to have intentionally failed to file or pay your taxes. If you filed a fraudulent return, you could face jail time of up to three years and fines of up to $100,000. Tax evasion criminal charges could mean penalties of up to five years in jail and fines of up to $250,000.

Failure to File and Failure to Pay Penalties

These two basic penalties are usually civil penalties that may apply if you don’t file your tax return by the deadline or don’t pay your tax bill on time. Here are details for each:

  • Failure to file: This penalty applies when you don’t file your return by the due date. It is 5% of your unpaid bill for each month, not to exceed 25%.
  • Failure to pay: This penalty applies when you fail to pay what you owe by the deadline. It is 0.5% of your unpaid bill for each month, not to exceed 25%.
  • If you have both of these penalties in the same month, the failure to file penalty will be lowered by the amount of failure to pay penalty for that month. Together, these penalties can get up to 50% of your balance due.

Auditors can apply these penalties retroactively if they discover that you have unfiled returns or unpaid taxes.

What Happens If You Get Audited and Owe Money?

A common outcome of failing a tax audit is an increased tax liability. But you still have options if you owe the IRS additional funds after failing an audit. Let’s look at what you can do to get everything paid off:

  • Make the full payment: If you are able, pay the full amount you owe the IRS. This is the quickest way to comply with requirements and get the IRS off your back. Follow the instructions on your penalty notice to submit your payment.
  • Set up an installment agreement: If you can’t pay your complete bill right now, consider applying for a payment plan, where you will pay a monthly payment until the debt is paid off under an agreed-upon time period with the IRS. There are both short-term and long-term installment agreements.
  • Send an offer in compromise: You may be able to send the IRS an offer along with proof that you cannot pay what you owe. The agency may then agree to settle with you at a lower amount.
  • Ask for currently not collectible (CNC) status: CNC is a temporary status that applies if you have a financial hardship. The IRS will stop collections against you until your situation improves, but this doesn’t mean your debt is forgiven.

The best way to get back on track with the IRS is to be open and honest and set up a payment arrangement you can comply with. You can also talk through your options with a tax or legal expert, who can guide you through the best way forward.

Best Practices to Avoid Audit Penalties

Audit processes and penalties will vary based on your situation, your mistake, and your unpaid tax liability. But they are actions you want to do everything you can to avoid.

The good news is that there are several steps you can take to prevent audits, avoid audit penalties, and stay in good standing with the IRS. Here are some best practices to consider:

Pay and File on Time

Always pay attention to annual tax deadlines, and file and pay each year before it’s too late. Best practice is to file as soon as you receive all necessary tax documents from employers, clients, and financial institutions. The tax deadline is typically April 15, but if that date falls on a weekend or holiday, the due date is the next business day.

Some business owners may be required to file and pay estimated taxes throughout the year, in addition to filing their annual return. Those deadlines typically fall on April 15, June 15, September 15, and January 15. These are also the deadlines for payroll tax returns, and as of 2024, the IRS is auditing returns with employee retention credits at relatively high rates.

Apply for Relief When You Can’t Pay

The IRS does offer several tax relief options to taxpayers who have trouble paying what they owe. Consider setting up a payment plan, sending an offer in compromise, trying for CNC status, applying for innocent or injured spouse relief, or applying for penalty abatement.

The truth is, you will only get into more trouble with the IRS if you try to avoid your tax obligation or hide anything. Be open and communicate your hardship, and the IRS will often work with you to get your liability paid off.

Never Provide False Information

Some taxpayers try to inflate their deductions and credits or lower their taxable income so they don’t have as big of a liability. Providing this false information can lead to severe fines and penalties and even legal charges, such as criminal fines and prison time. It is never worth these risks to falsify your information.

Check for Errors in Your Return

Another way to avoid tax issues is to double- and triple-check your tax return information before submitting it. What may just be a simple mathematical error could lead to penalties. When in doubt, go over everything with a tax professional who can help you ensure you’re following all laws and regulations properly.

Dealing with the Consequences of a Failed Tax Audit

The IRS has three years to audit most tax returns. If you file and pay late, the IRS can audit two years back from the date you paid the tax due. However, if you don’t file a return, the agency can go back an unlimited amount of time.

Tax audits are never fun to deal with, nor are the consequences and penalties associated with failing an audit. However, by understanding potential audit outcomes, complying with all audit instructions, and being proactive with your tax return, you can do everything you can to stay in good standing with the IRS. Being honest and responding quickly are great ways to stay compliant.

Another way to deal with penalties and audits is to work with a legal tax team. At Seattle Tax, our team of experts delivers tax resolution services to help you navigate any tax issue you may be dealing with, including tax audits, tax debt, back taxes, and tax penalties. We understand applicable tax laws and will help you negotiate with the IRS. Contact Seattle Tax today to get started with our tax law firm.