A tax audit is a stressful time for a small business owner, adding fear to the already exhausting list of entrepreneurial challenges.
If you are selected for a tax audit, depending on the depth of the investigation and how well prepared you are, you can spend hundreds of hours gathering documentation to fulfill the auditor’s requests.
For all returns filed for Tax Years 2010 through 2018, the IRS audited 0.63% of all individual tax returns filed and 1% of corporate income returns. But if your business is one of the unlucky few, taking the appropriate steps in the care of an IRS audit can help ensure this stressful event leads to a more favorable outcome.
Table of Contents
1. Fight the Urge to Panic
When you receive a tax audit notice, you might feel like the IRS is out to get you. But consider this: In-depth field tax audits are rare.
These days, the most common IRS audit is a correspondence tax audit, making up 72.6% of all tax audits for fiscal year 2020. Correspondence tax audits are more like error corrections. Have you heard of IRS mail audits? An IRS agent may ask you to mail in support of the information reported on your tax returns or simply send you an invoice for the additional tax owed due to a missed 1099 or a math error. If you have the documentation, it shouldn’t be a problem to mail it in and have your file closed.
Field IRS audits are more comprehensive and tend to be the ones that taxpayers fear the most. They’re usually held at your place of business or your accountant’s office. They can involve hours of review and verification of things like itemized deductions, income reported, charitable deductions, and more by IRS agents.
However, the IRS office has faced years of budget cuts and personnel reductions, so field audits don’t happen often. In most cases, the IRS must suspect fraud or believe that you underpaid your tax enough to justify the expense of occupying IRS agents for weeks or months on end managing an IRS audit.
2. Gather Necessary Documents or Reports for Backup
If you are selected for a field audit, the IRS will provide a written request for the specific documents they want to see. That may include receipts, bills, canceled checks, copies of contracts or other legal documents, loan agreements, travel logs, and employment documents.
Take some time and work with your tax preparer or another tax professional to gather the necessary documents, reports, and backup documentation. If you’re already using a cloud accounting solution, it should be easy to print your Profit & Loss statement and any other reports you need for the year(s) in question. You’ll want to make copies of any bank statements, receipts, or other documentation for the auditor to take with them so you can keep originals for your records.
Be extra diligent about records for unusual deductions or large meals and travel expenses. IRS auditors cover many returns, so they have a gauge of what income and expenses are typical for different types of businesses. IRS auditors tend to take a particularly hard look at meals and travel expenses because these areas are prone to abuse.
Of course, often, there are perfectly legitimate reasons for any unusual expenses and high travel expenses that make their way into tax returns, so keep records for these items and document their business purpose.
The best defense is a good offense, so business owners who keep detailed, organized records are in a much better position than those who need to chase down documents, dig through piles of paperwork to procure what the auditor needs, and seek out last-minute tax advice from tax professionals.
3. Look for Additional Deductions
Oops, you accidentally forgot to include some revenue on your tax return or erroneously claimed deductions on tax returns for which you weren’t eligible. It happens, however, the IRS will assess the additional tax due, plus interest from the date the tax should have been paid. They may also assess penalties.
But before the auditor closes the file, make sure you didn’t miss any deductions that can offset the increase in taxable income.
Many taxpayers overlook common reimbursable expenses and deductions, such as business mileage, home office expenses, charitable contributions, or expenses paid for with a personal PayPal account or credit card. All of these should be appropriately included on your tax return to generate the best possible tax refund.
So take some time to review your Expense Report and compare it to bank and credit card statements. Along with documentation requested by the auditor, submit documentation for overlooked deductions. If you can come up with enough legitimate expenses, the auditor just might find that you deserve a refund!
4. Get Creative: Substantiate Your Deductions
Maybe you weren’t very diligent about keeping records during the year under IRS audit. Even if you’re missing some receipts and records, those deductions don’t have to be lost.
In many cases, the IRS allows for third-party documentation, oral testimony, and other forms of verification to substantiate expenses included in your tax return. For example, if you drove your personal vehicle for business but forgot to keep a mileage log, you may be able to recreate the mileage log using your calendar, Google maps, and client records.
If you are missing receipts for miscellaneous expenses included in your tax return, it may be possible to request another copy from the vendor. I did this recently when I lost the hotel receipt for a business trip. As soon as I realized the receipt was missing, I called the hotel, and they emailed me a new copy of my hotel folio. Fortunately, IRS audits aren’t an issue for me at the moment, but if the IRS ever decides tax audits are in my future, I won’t have to worry about having a significant travel deduction denied.
5. Seek Professional Help
While it might be a little late at this point, it’s worth noting that professional tax preparation goes a long way in not only avoiding an audit but dealing with one. If you feel overwhelmed with the idea of talking to an IRS auditor, it may be a good idea to enlist the tax advice and legal advice of a tax attorney, enrolled agent, or CPA.
Hiring an accountant or attorney to manage the audit process does cost money, but it can help relieve you from handling all documentation requests. Plus, professionals are experienced in dealing with tax law and auditors. How much do you know about tax law? I’d guess as much as I do…
For a field audit, the auditor will set up an initial meeting in which they’ll interview you (or your representative) to ask questions about your return. Be honest and respond as thoroughly as you can, but don’t volunteer additional information. An audit that starts out looking at one issue can expand into other issues, other tax years, and even the tax returns of other people and businesses if the auditor uncovers something questionable. Letting a tax professional do the talking for you can help you avoid blunders that tend to make audits drag on endlessly.
Once the audit is over, the auditor puts together an examination report detailing the findings and how much, if anything, the auditor believes you owe in back taxes and penalties. You can either agree with their conclusions and sign the examination report or dispute it by going through the IRS’s Fast Track Settlement program or filing an appeal. Your tax pro can help you decide which method is right for you and guide you through the process.
Be Cordial During IRS Audits
Whether you choose to hire a professional or go it alone, make an effort to stay on good terms with the auditor. While you absolutely should ask questions and stand up for legitimate deductions and tax return positions, keep in mind that auditors can dismiss or lower penalties if they choose. Be honest, reasonable, and professional with your auditor, and you should get the same treatment back in return.
This post was updated in November 2021.