Q I just received a letter from the IRS demanding additional taxes, interest, and penalties for my 2023 tax returns. Apparently, I failed to report dividend income from a mutual fund I own. Does this mean I am being audited?

A Just the thought of opening a letter from the IRS is enough to make your stomach do cartwheels. If that letter has been sent to inform you that your tax return has been selected for audit, your nausea will be followed by cold sweats, a telephone call to your tax preparer, and perhaps, a newfound interest in religion. For those of you that suffer from IRSphobia, the following is a brief outline of how the audit selection process works.

The IRS performs certain preliminary checks of every tax return filed and selects returns to be examined based on various criteria. Every tax return is first checked for mathematical accuracy. If the tax return contains a computational error, the IRS will send a letter with the corrected computation along with a notice and demand for payment. The massive IRS computer will then compare all income tax returns with information returns, such as wages (Forms W-2), and interest and dividend statements (Forms 1099). If there is a mismatch, the IRS sends a computerized notice (CP-2000) which identifies the discrepancy and recalculates the tax due plus interest and penalties. The CP-2000 can be challenged by the taxpayer, who has the burden of proof. Usually, a letter (or two, or three….) will be required to resolve the issue if the taxpayer is correct. If the IRS is correct, then payment of the tax plus interest must be made. However, the taxpayer may be able to have the assessed penalty abated if reasonable cause is given in writing.

The IRS selects tax returns for audit examination based on discrepancy with information returns, history of deficiencies, unusually high deductions, random sampling, and unusual refunds. The IRS computer also selects tax returns for examination using a procedure that ranks returns having the greatest audit potential. For example, a return that has an extremely high charitable contribution deduction for that particular adjusted gross income level may be “kicked out” by the computer for audit review.

The IRS may also select returns from a particular industry (real estate brokers, attorneys, retail cleaning establishments, etc.). These audits are generally performed by agents who have been specifically trained to understand the accounting and tax nuances of the particular industry under review. The printed guides provided to the IRS agents are also available to tax practitioners.

The percentage of tax returns selected for examination varies each year depending on the available IRS budget and staff. Obviously, tax returns of those individuals who receive only income subject to withholding taxes, and those who do not itemize their deductions are least likely to receive that notice of audit.

Approximately 1.5 to 2.0% of all income tax returns (individuals and businesses) are audited each year. The actual chances of being audited vary sharply depending on the geographical location, entity type and entity size. Please note that the IRS has recently been beefing up their auditing capacity!

If your return has been selected for audit, it is essential that you understand your rights prior to any in-person review or meeting with the IRS agent. You need to know your rights during the initial audit examination as well as your appeal rights if you disagree with the audit findings. A taxpayer may choose an individual (CPA, attorney, enrolled agent, etc.) with a written power of attorney (Form 2848) to represent them during the audit. Without a summons, the IRS may not require a taxpayer to accompany the representative.

The good news is that your letter appears to be a CP-2000 issue and NOT an audit. If you believe the proposed income changes are accurate and the tax calculations are correct, pay the billed additional tax, interest and penalties immediately. Also, you may need to file an amended state tax return to report the changes.

Barry Dolowich is a certified public accountant and owner of a full-service accounting and tax practice with offices in Monterey. He can be reached at (831) 372-7200. Please address any questions to Barry at PO Box 710 Monterey, CA 93942 or email: bdolowich@gmail.com.