Don’t Sweat It: IRS Letter 566 and Audits

Few things are scarier than receiving an IRS notice in your mailbox. Before getting so worked up about breaking any tax laws, make sure you fully understand what they are asking from you.

If your tax return has been selected for a tax audit, don’t panic. It’s usually from an unusual situation or a mistake common too many taxpayers. And the majority of these audits are what the IRS calls correspondence audits - meaning they are completed solely through the mail. No IRS agent will show up at your house or place of business.

The audit process starts with the IRS letter 566.

What is IRS Letter 566?

Each year the IRS uses computer software and algorithms to identify tax returns that may have potential errors or common unallowable deductions or credits. Fortunately, the likelihood of your tax return is flagged for audit is quite low. In 2019, less than 1% of all tax returns filed were selected for audit.

When the IRS’s software identifies a tax return for audit, a 566 Letter is sent to the taxpayer. The letter will let you know which tax year they selected and which specific item is under correspondence audit.

Rarely is an entire tax return under audit. Generally, the Internal Revenue Service is looking at specific items like W-2 wages, business income, automobile expenses, or tax credits. And the 566 Letter will let you know which specific items were selected from your individual tax return.

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Why would you receive a 566 letter?

Although the IRS reviews a small percentage of tax returns, they look for common and frequent errors. These potential errors could be mismatched reporting or unusual variations in your tax return from year to year.

Some examples of these errors that might generate a 566 Letter are:

• Business income on Schedule C on your tax return doesn’t match income reported on Form 1099-NEC or Form 1099-MISC.
• Current year’s deduction for automobile expenses or charitable contributions (other any deduction) is significantly higher or lower than previous years.
• Taking a tax credit, like the Earned Income Credit, this year that you’ve historically not taken, or vice versa — not taking a tax credit that you historically do.

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What to do after receiving a 566 letter

First things first: Don’t panic and don’t ignore it.

Read through the letter slowly and carefully to learn what additional information the IRS is looking for from you. Most of the time these audit notices just require you to provide documents or receipts the IRS doesn’t have access to that will support your income or 1099 tax deductions.

You should keep all your documents, receipts, reports, and forms you used to complete your tax return for at least three years after you file. This is how long the IRS has to audit your return. But if they find substantial errors on your return, they can go back and look at six years of tax returns. A good rule of thumb is to keep all your tax documents for at least six years.

The 566 Letter will come with additional documents that will clearly state what is needed to satisfy the IRS.  Don’t ignore their request. If you don’t respond, the IRS will disallow the questioned items and make changes to your tax return.

For example, you filed as head of household last year for the first time when you’ve historically filed as Single and the 566 Letter states this is the area of your tax return that’s under audit. Form 886-H-HOH should be included with the 566 Letter. Form 886-H-HOH will detail the exact documents you’ll need to submit in order to prove you qualify for the head of household filing status.

Pull the documents out of your tax file, contact your CPA, or gather the needed documents and make copies to send to the IRS. Don’t send originals, unless the IRS expressly states that originals are needed.

The 566 Letter will state how you should submit your documents. Typically the IRS will accept documents through mail or via fax. Email or online document submission isn’t currently allowed.

Timeliness is key. Typically you’ll have only 30 days to respond before the IRS takes further action that can include issuing a Notice of Deficiency, or a 90-day letter, that you owe additional taxes and have 90 days to pay this increased tax liability.

However, if you need extra time, you can call the IRS office that issued your letter and explain your situation and ask for additional time.

Keep copies of all information you return to the IRS in a safe place so that if there are questions or further information is needed, you’ll have quick access to your response.

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What happens after you submit documents

Once the IRS has reviewed the documents you supplied one of two things will happen.

1. No changes to your tax return will be made if the information you send fully addresses their questions. You’ll receive a letter from the IRS stating such and no further action is required by you.
2. If the information you sent doesn’t fully answer their questions, you’ll receive a letter explaining the proposed changes to your tax return and the actions you’ll need to take.

If you receive response #2, don’t worry. You have the right to fully understand why the IRS is making changes to your tax return. If you don’t or if you feel the documents you provided were adequate, you may need to call the phone number at the top of the letter. Speaking to an IRS employee or tax professional may help shed light on the proposed adjustments, which can be difficult to do in a letter.

Receiving an IRS audit letter doesn’t have to be stressful. When you keep your tax documents, credit card records for taxes, and debit card statements organized you’ll be able to answer their questions easily and resolve the audit quickly. If you receive an IRS audit letter, schedule a free consultation with an experienced tax attorney to build an audit defense.