State and federal tax audits share some similarities, but they differ in scope, triggers, and potential consequences. If your tax client is being audited by the Internal Revenue Service (IRS), the federal agency responsible for administering and enforcing U.S. tax law, their state department of revenue, or both, they’ll likely have questions about what they should expect.
This article breaks down the key differences between state audits vs. federal audits, explains how one can trigger the other, outlines common audit triggers, and highlights risks such as criminal exposure. You’ll also learn how to support your clients through the process, including representation strategies and ways to help them stay informed and prepared.
What’s the difference between a state and a federal tax audit?
While both types of audits aim to verify the accuracy of a taxpayer’s return, the key distinction is who conducts the audit and what they’re looking to review. Federal audits focus on federal tax returns and are performed by the IRS. State audits focus on state tax returns and are performed by the state Department of Revenue. Although these audits often happen independently, they can intersect, especially when discrepancies in one return raise red flags in another.
State audits
State tax audits are conducted by the state Department of Revenue and focus on verifying compliance with state tax laws. These audits typically examine state income tax returns, sales and use taxes, residency status, and other state-specific tax laws.
Each state has its own rules, thresholds, and audit triggers, which means the extent fo what the audit covers, and the audit process can vary significantly depending on where your client filed. Unlike federal audits, state audits may also closely evaluate local business activities and regional tax incentives, making it important for tax professionals to understand the nuances of each jurisdiction.
Federal audits
Federal tax audits are conducted by the Internal Revenue Service and center on the federal income tax return. The IRS reviews returns for accuracy in income reporting, deductions, credits, and other items governed by federal tax law.
The IRS chooses how to conduct an audit based on serval factors, including the complexity of the issue, the amount of money involved, and the type of information they need to verify. Depending on the situation, audits may be carried out in one of the following ways:
- Correspondence audit: This is essentially an audit by mail, where the IRS sends a letter requesting clarification or documentation related to specific items on a return. It’s typically the simplest form of audit and doesn’t require any in-person meetings.
- Office audit: Held at a local IRS office, this audit requires the taxpayer to meet with an IRS agent and bring relevant records for review.
- Field audit: The most comprehensive type, where an IRS agent visits the taxpayer’s home, business, or accountant’s office to conduct an in-depth examination of financial records.
Because the IRS oversees nationwide compliance, federal audits often involve a wider range of issues compared to state audits. This broader oversight can lead to additional scrutiny. In some cases, a federal audit may trigger other investigations such as a state tax audit, employment tax audit, prior-year audits, or even a criminal investigation if repeated errors or signs of intentional noncompliance are discovered.
What are the common income tax audit triggers?
Certain factors can increase the likelihood of a tax return being flagged for an audit. Many of these triggers will apply to both federal and state returns.
- Very high income
- Unusual deductions compared to others in the same income bracket
- Unreported Income
- Multiple taxpayers claiming the same dependent
Some factors increase a person’s likelihood of facing a state audit but not a federal audit. Taxpayers are more likely to face a state audit if they:
- Work in a different state than the one they live in
- Own a business that operates in multiple states (or creating a nexus in more than one state). Understanding these common triggers can help you to proactively address potential issues before they lead to an audit.
Does a state audit trigger a federal audit or vice versa?
A state audit doesn’t automatically trigger a federal audit or vice versa. Because the IRS and the individual state Departments of Revenue investigate two separate tax returns, it’s possible for a client to be audited by one agency without being flagged by the other.
For example, if a state audit is simply the result of typos or simple mistakes on your client’s state tax return, it’s possible that their federal return did not have any of the same issues.
However, larger mistakes or intentional falsehoods in filing are more likely to trigger an audit. For example, if a client falsely claimed a dependent or failed to report all their income, these issues likely exist on both returns, and the IRS and state organizations will often notify each other in these instances. In these cases, it’s very probable that the individual will be audited by both their state and the IRS.
Can my client be audited by the state but not by the federal government?
Yes, a client can be audited by the state while not being audited by the federal government. State and federal audits operate independently, and each has its own criteria and processes for selecting entities for an audit. A client might have specific issues or discrepancies that trigger a state audit but not raise any concerns at the federal level, or their financial activities may only concern state tax regulations. Each audit will focus on the relevant laws and regulations applicable to that particular jurisdiction.
Who can represent my client in a state or federal tax audit?
In a federal audit, you can represent your client if you have the proper credentials. The following people can represent individuals before the IRS:
- Attorneys
- Certified Public Accountants (CPAs)
- Enrolled Agents (EAs)
- Non-credentialed tax preparers who have completed the IRS’s Annual Filing Season Participant Program (AFSP), a voluntary program that provides limited representation rights for preparers who meet continuing education requirements, but only if that person also prepared the tax return
Attorneys, CPAs, and EAs have unlimited representation rights before the IRS. This means they can represent clients in all matters, including audits, payment issues, and appeals, regardless of who prepared the tax return. Non-credential tax preparers will have limited representation rights.
Most states have similar guidelines for representation in a state tax audit, although they may not grant representation rights to non-credentialed tax preparers. Each state will have different laws for audit representation, so be sure to check that state’s guidelines.
When considering taking on a new client undergoing an audit, it’s important to evaluate your ability to manage the complexity of their situation. If an audit is complex or outside of your area of expertise, referring the client to someone more specialized may be wise. Assessing the client’s organization and compliance history can also help determine if you can effectively assist them through the audit process.
TaxSlayer Pro partners with top-tier resources in the tax preparation industry like Audit Maintenance Pro and Protection Plus to provide comprehensive identify protection for your clients and valuable education opportunities for your employees.
What happens during a tax audit?
A tax audit is a structured review process in which a taxing authority, either the IRS at the federal level or a state department of revenue, examines a tax return to verify that the information reported is accurate and complete. While the format and timeline may vary, most audits follow a similar sequence of steps and typically focus on specific items rather than the entire return. Here’s an overview of what tax preparers and their clients can expect during and audit:
- A notice or letter is issued informing the taxpayer that their return has been selected for audit and outlining the scope of the review
- The agency requests documentation to support specific items on the return, such as income, deductions, or credits
- An auditor reviews the submitted records to determine whether the reported amounts are accurate and compliant with tax laws
- Follow-up questions or additional requests may arise if clarification or more documentation is needed
- Findings are issued, which may result in no changes, proposed adjustments (such as additional tax owed or a refund), or next steps like an appeal or further review
Understanding this general process can help you set clear expectations for your clients and guide them through each stage with confidence.
Do state and/or federal audits result in criminal charges?
Not usually. Many people automatically associate “audit” with “criminal investigation,” but this just isn’t always the case. Both states and the IRS can prosecute criminal tax fraud and evasion, but audits are much more frequently resolved without any criminal charges. Of course, if your client knowingly committed tax fraud, criminal charges are a possibility, and they may need the services of a tax attorney.
How do I provide support to my audited clients?
You can support audited clients by representing them, guiding them through the process, or connecting them with trusted resources. If you have representation rights before the IRS and their state Department of Revenue, your clients may want you to represent them during the audit. You can help them gather necessary documents, dispute the findings of the audit, and settle on a payment plan if it is found that they owe money.
Even if you can’t formally represent your client, you can help them know what to expect when a return is flagged.
You can also point them to resources for help and representation such as Audit Maintenance Pro or Protection Plus’s audit assistance professionals. The benefits of audit protection extend beyond relieving your clients’ stress and financial burden during audits. By incorporating this service, you can also differentiate your tax practice with a unique offering in the market.
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