The word audit might be one of the most dreadful words in the dictionary—and for good reason. No one wants to receive a letter in the mail from the IRS or their state’s Department of Revenue stating that they’re going to conduct a tax audit. Audits can be a major inconvenience at their best and a very costly process at their worst. Navigating both federal and state tax audits can be a headache. You may be audited by the IRS, your state, or both. But will a state audit trigger a federal audit? Not necessarily. While the IRS and states share information with each other, it doesn’t mean one audit will trigger the other. However, a blemish on your state tax return can impact your federal return, and vice versa, which can trigger an audit. If you’ve received a letter notifying you of an audit, or if you’re worried you may be audited, we’ve created this guide on state audits vs. federal audits, so you can know what happens when you get audited by the state or IRS. Read end-to-end to learn all there is about state and IRS audits, or use the provided list below to jump to a section that may contain the answer you’re looking for.
- What Is a Tax Audit?
- State Audits vs. Federal IRS Audits
- Will the IRS Find out About My State Audit?
- What Happens When You Get Audited by the State?
- Will an IRS Audit Trigger a State Audit?
What Is a Tax Audit?Before diving into state tax audits and federal tax audits, it’s important to know what an audit is first. A tax audit is when the IRS or your state’s Department of Revenue examines your federal or state tax return to ensure your income and deductions are accurate. If either agency finds discrepancies on your tax return, they may issue fines, penalties, or even jail time depending on whether they find you guilty of fraud.
State Audits vs. Federal IRS AuditsSo, what’s the difference between a state audit vs. federal audit? The main difference between a state audit and federal audit is the governing body that issues it. State tax refund audits are conducted by your state’s Department of Revenue, while federal audits are conducted by the IRS. Below is a closer look at each type of audit.
State AuditsCan you be audited by the state? Yes. State audits are conducted by your state’s Department of Revenue and shouldn’t be ignored or swept under the rug. Any type of audit is serious. When an audit comes from the state, it means your state believes there is an error on your state tax return. While an audit doesn’t necessarily mean you owe money or lied about your income or deductions, it does mean there is some misunderstanding between you and the state regarding your tax return. If you do receive notice of an audit, it’s always best to be prepared and have all the necessary documents, such as receipts and transactions, to prove you filed your return accurately. According to a study by TaxAudit.com, it was found that Hawaii, New York, Delaware, Michigan, and Massachusetts were the top five states to conduct state audits. For example, Michigan has a high rate of state tax return audits because a large portion of the population works in neighboring states like Ohio, Indiana, and Illinois, which complicates state tax returns. New York, on the other hand, contains one of America’s largest cities and is located in the tri-state area, with New Jersey and Connecticut as its neighbors. The dense population paired with taxpayers working in other states leads to an increase in state audits. The fact alone that you live in one of these states doesn’t mean you have a higher chance of being audited. Rather, it has to do with certain factors, such as income. It’s known that taxpayers with higher incomes are audited more often, as this can result in the state earning more money. According to data from the Census, four of the top ten states on TaxAudit’s list fall in the top 20 percent for household income. It’s important to remember that anyone, anywhere, and at any time can be audited. However, there are certain red flags that can trigger a tax audit, which we’ll discuss next.
What Triggers a State Audit?There are a few red flags that might result in your state conducting an audit. Take a look at the most common state audit triggers:
- Nexus: Nexus refers to a situation where a company has a tax presence, or nexus, in a certain state or multiple states. Because each state has its own tax laws, nexus can complicate state tax returns for businesses that operate in several states, such as those who sell on Amazon or have numerous locations across state borders. Once nexus is established, businesses must register for use and sales tax. If not, and a state finds out you’re conducting business in their territory, they may audit you.
- Use tax: Use tax is a sales tax on taxable items that are purchased in another state and are intended to be used, stored, or consumed in a person’s or company’s state of residence. It can be easy to forget to report use tax, such as recording inventory transfers, charitable donations, or promotional giveaways that promote sales, which makes this a common trigger for a state audit.
- Sole proprietors: Sole proprietors, compared to LLCs, C Corporations, and S Corporations, are more likely to be audited because they often file self-prepared returns. This increases the likelihood of making a mistake, which is why state revenue agencies seek out sole proprietors more often.
Federal IRS AuditsThe federal government also has the power to conduct an audit. The IRS reviews your federal tax return, not your state tax return, and looks at your accounts and financial information to ensure you reported it correctly in accordance with the tax laws. There are a few reasons you may be selected for an IRS audit:
- Random selection: The IRS uses a computer programming system to process federal tax returns. Through computer screening, a statistical formula is applied that compares your tax return against the norms of similar tax returns. To develop the norms, they collect a statistically valid random sample of returns, which could happen to be you.
- Related examinations: If you have issues or transactions with other taxpayers, such as investors or business partners, whose tax returns were selected for audit, you may be selected too.
- Canceled checks
- Legal papers
- Loan agreements
- Logs or diaries
- Medical and dental records
- Theft or loss of documents
- Employment documents
- Schedule K-1
What Triggers an IRS Audit?Similar to state audits, numerous triggers can lead to a federal tax audit. Take a look at some of the most common IRS audit triggers below:
- Too much or too little income
- Typos and math errors
- Unreported income
- Excessive tax deductions
- Deducting 100 percent of a business vehicle
- Failure reporting cryptocurrency
- Cash-based businesses
- Claiming the Earned Income tax Credit
- Self-employed workers
- Home-based businesses
- Claiming a hobby as a business
Will the IRS Find out About My State Audit?A common question many taxpayers wonder is, “will a state audit trigger a federal audit?” The answer? It depends. States and the federal government communicate with each other. However, this doesn’t mean the state will notify the IRS that they’re auditing your tax records. But, if the state requires you to make a change to your return, it can have an impact on your federal tax return. If those changes aren’t adjusted, the IRS might notice and conduct an audit. For example, if you try claiming multiple deductions on your state tax return that you’re not qualified for, your state will most likely report this to the IRS. This will prompt the IRS to look at your federal tax return to look for excessive tax deductions. In any case, it’s important to be honest, thorough, and transparent. Only apply for tax deductions and credits you qualify for, report all of your income from every source, and double-check your math.
What Happens When You Get Audited by the State?When you get audited by the state, your state’s Department of Revenue will send a letter in the mail, providing directions on what steps to take to comply with the audit. Audits will either take place through mail correspondence, where they ask you to send information to verify the statements you provided on your state tax return, or through in-person interviews, where you may need tax audit representation. If this is the case, a Community Tax representative can provide tax audit support to ensure you get the best possible outcome. There are a variety of reasons why states conduct audits on state tax returns. The most apparent reason is that states need to collect revenue. Other reasons include, but are not limited to:
- Ensuring businesses within the state are collecting sales tax and the right amount
- Identifying out-of-state businesses that might have nexus in-state
- Determining different types of transactions that are taking place to create new tax laws