I am being audited, what do I do?

Okay so in 2008 I received an early distribution from an ESOP retirement plan that I had with a company I worked for. I paid the 10% penalty for taking an early distribution I remember that. I didn’t put it on my taxes because I thought I already paid taxes on it so I didn’t need to include it. Not the case apparently. It supposedly was a 1099-R. If I amend my return and add this to it will that solve my problem? What happens if I do nothing?
Does it matter that I only made 14000 that year not including the 1099r of 7000?

Did you receive a notice (CP-2000 or similar number) saying that you failed to report this income? If so, review it for accuracy. It should be including the income, revising the tax,setting forth the 10% penalty and showing the additional withholding (10%).

If it all looks correct, you sign the notice and remit the amount they are asking for. It is not necessary to file Form 1040X as they have already made the calculations.

You did need to include the 1099-R on your return, which is why you have now received this notice. The withholding only covered the penalty, not the income tax on the distribution.