Will A State Tax Audit Trigger A Federal Tax Audit?

Any Tax Audit Can Be Stressful And Handling Two Tax Audits At Once Is Even Worse

If you’ve received an audit letter from your state tax agency, you might be nervous.

You probably know an audit can be an unsettling, inefficient process. You might be worried that interest could be accruing before you’re even aware you owe anything.

Of course, one audit is bad enough. And now you’re wondering… Is a federal audit next?

The answer: It depends.

The first thing you need to know is that the IRS and state tax agencies do share information.

You can take a breath knowing that an audit at the state level won’t necessarily trigger an audit at the federal level.

However, you must also be aware that the IRS will probably take notice if your state audit reveals a material change in your income or deductions.

In either case, an experienced tax attorney can represent you in a state or federal tax audit and negotiate on your behalf.

What Is A Tax Audit?

First, let’s recap some basics.

A tax audit is a review of your business or personal tax information to ensure the information you provided is correct. Auditors will be looking to verify your income and deductions.

A discrepancy or mistake — no matter how innocent or unintentional — could lead to fines, penalties, and interest on back taxes owed.

Worse yet, if the government determines you willfully committed an error when filing, you could be prosecuted for criminal fraud.

If you are entitled to all the losses and deductions you claimed (and you have the documentation to support them) you shouldn’t fear an audit.

Nevertheless, it can take a lot of work to defend yourself through the audit process.

Getting a tax lawyer like Attorney Sammy Kim involved early on can help you avoid costly mistakes, missed deadlines, and miscommunication.

What Triggers A State Tax Audit?

Your state tax agency looks for red flags that indicate an audit might be warranted.

These red flags aren’t necessarily a sign of wrongdoing. Many taxpayers are flagged simply because they fall into a category in which errors and fraud are more common.

It’s just more efficient to target the taxpayers most likely to make a mistake.

Common factors that can trigger a state tax audit for small businesses:

• Operating a sole proprietorship
• More independent contractors than employees
• Meeting payroll in cash
• Operating in multiple states
• Reporting business losses year after year
• Claiming 100% business use for your car
• Claiming a home office deduction
• Having used a COVID-19 relief program

As we explain below, an IRS audit can be another factor leading to a state audit.

Factors that can trigger an individual income tax audit at the state or federal level:

• Unreported income
• Very high income
• Unusually high deductions (compared to others in your income bracket)
• Multiple caregivers claiming the same dependent
• Working in a different state than the one you live in (state audit only)

Do States Share Information With The IRS?

Yes, state and federal agencies actively share information with each other. The goal is to deter tax fraud and save government resources in the process.

Tax agencies don’t necessarily notify each other that an audit is underway. In other words, a state audit in progress should not affect the processing of your federal return.

However, if the state finds that adjustments are required, that information will be communicated.

Generally, if either agency finds that additional taxes are owed, you will typically receive correspondence from the other.

Due to information sharing (and improvements in information-sharing technology), many taxpayers do have to deal with multiple audits.

Be aware that it can take months between a state audit finding and an audit request from the federal government (and vice versa). Don’t assume you’re out of the woods just because you haven’t heard anything!

It is possible, however, that some adjustments are only material at the state or federal level.

For example, if you make an error reporting your 529 savings plan contributions, your federal return would not necessarily be impacted.

It’s also possible that you made a simple mistake or typo on one return but not on the other – meaning no corrective action would be required.

Do I Have To Report An IRS Audit Adjustment To The State?

Do you have to? It depends on where you live or do business. Should you? Usually, yes.

Many states require taxpayers to report federal adjustments to their state tax authority. (Yes, even though the IRS is sharing this information, you can still be required to report it yourself.)

The rules vary by state. Some states require you to file an amended state tax return; others require a form or other correspondence. Deadlines can vary too, anywhere from 30 days to five years.

If you do business in multiple states, just one change on your federal return can require you to file multiple amended state returns or forms. Thanks to a patchwork of state rules, forms, and timelines, that can be a complicated and time-consuming endeavor.

Generally, if you know an audit outcome will have a material impact on your state or federal return, it’s often best to be proactive and file an amended return.

Failure to notify the state of a federal adjustment could result in penalties and interest.

Sometimes, it may even be in your best interest to make advanced payments – in anticipation of a state audit adjustment – to reduce your interest expenses on back taxes owed.

What If I’m Contesting My Audit?

Some states will automatically change your state tax bill, based on an IRS adjustment.

So, if you plan to contest an IRS audit in court, notify your state tax department. Provide a copy of your court petition and ask that any state action on your case be put on hold.

What If I Can’t Afford To Pay Both State And Federal Tax Bills After An Audit?

Both states and the IRS will typically grant installment agreements if you can’t make the full payment right away.

Likewise, both entities may be willing to settle a tax bill you can’t afford to pay. However, both agencies can seize your assets and/or take other enforced actions if you don’t make prompt arrangements.

If you are concerned about settling a tax bill with the state or the IRS, talk to Attorney Sammy Kim right away. She can take the proactive steps necessary to negotiate your state and federal tax liabilities and minimize penalties.

Better yet, contact Attorney Kim as soon as you’ve received an audit letter from either a state or federal agency. She can manage your audit defense and coordinate any subsequent state or federal reporting that may be required.