Basics of Income Tax and Auditing

Definition and Introduction:

According to COBUILD Advanced English Dictionary, "Income tax is a certain percentage of your income that you have to pay regularly to the government."

"Annual charge levied on both earned income (wages, salaries, commission) and unearned income (dividends, interest, rents). In addition to financing a government’s operations, progressive income taxation is designed to distribute wealth more evenly in a population and to serve as automatic fiscal stabilizer to cushion the effects of economic cycles. Its two basic types are (1) Personal income tax, levied on incomes of individuals, households, partnerships and sole-proprietorships; and (2) Corporation income tax, levied on profits (net earnings) of incorporated firms. However, presence of tax loopholes (whose number increases in direct proportion to the complexity of tax code) may allow some wealthy persons to escape higher taxes without violating the letter of the tax laws."- Business Dictionary

"A tax audit is an examination of an organization's or individual's tax return to verify that financial information is being reported correctly."- BUSINESS NEWS DAILY

Basic knowledge of income tax and auditing is necessary for an individual or business whether small or big because it is everyone’s duty to pay income tax properly to the government as citizens of an independent country.

Basic Concept of Income Tax Audits:

A Government income tax audit is a review of an individual’s or organization’s income tax return to ascertain the appropriateness and authenticity of that. It is to be noted that a tax audit is not an allegation of corruption rather it is an opportunity provided by the Internal Revenue Service (IRS) to qualify the information provided by the individual or organization as a tax return. 

As for example, consider the Government tax deduction for charitable contributions. If a person or organization mentioned that s/he or it donated a certain amount of money to any charitable organization, it depends upon that person/organization to present the proper documents to support the claim such as a receipt signed by the charitable organization’s recipient/employee and an item wise list of the donated items and their values (if available).

Individuals or organizations have to be sure about their qualifications to claim any tax breaks at the time of preparing their income tax return. In case of any misinformation or discrepancies found by the IRS, it’s quite sure that the business or individual will be audited. During income tax auditing that individual or organization has to present sufficient documents to prove the validity of tax credits and tax exemptions. Those who fail to provide the appropriate evidence for their claims will have to pay the difference in income taxes as well as any late fees and/or penalties. Persons or organizations should not panic after getting a notice from the IRS that they will be audited.

First, they have to read the letter entirely to ascertain what the IRS is asking them to do. They have to keep in mind that there are different kinds of audits and they have to find out which one is applicable to them. They may need to hire a Tax Audit Defense Representative depending on their circumstances to help them handle their case.

Types of Income Tax Audit:

There are mainly three types of income tax audit:

1. Correspondence Audit
2. Field Audit
3. Office Audit

• Correspondence audits are the most primary level of auditing executed by the IRS. A written request by the IRS is sent to the taxpayer for additional information about a particular issue or item on a particular tax return. If the taxpayer can supply enough documentation to settle the issue, the process is completed.
• A Field Audit generally takes place at the premises of the business or at the tax audit defense representative’s office.  The business or individual will be asked to supply supporting evidence or documents for the sectors in question. The income tax records should be clear, detailed, and organized.
• An Office Audit takes place at the IRS office mentioned in the letter or notice sent by them. Here, the individual or business or the tax audit defense representative has to attend a meeting where particular tax documentation/information specified in the IRS’ letter are required to be produced.

The IRS will give both the opportunity either to agree with the findings of the auditor or file an appeal within a particular timeframe, within 30 days of the income tax audit. In case the individuals/organizations agree with the findings of the auditors and they owe more income tax, they must immediately pay that tax and any penalties or interest due. In case of disagreement with the auditor’s findings, they have the option to make an appeal to the IRS Appeals Office. It is very crucial to keep in mind that they must respond within the timeframe mentioned in the letter while dealing with an IRS tax audit.

To avoid income tax audit in the future, an individual or business has to maintain proper financial records and ensure that the information provided on the income tax return is accurate and authentic.