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 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.
In 2015, the IRS audited 0.7 percent of all individual tax returns filed and 1.1 percent of corporate income returns. But if your business is one of the lucky few, taking the appropriate steps can help ensure this stressful event leads to a more favorable outcome.
1. Fight the Urge to Panic
When you receive an audit notice, you might feel like the IRS is out to get you. But consider this: in-depth field audits are rare.
The most common audit these days is a correspondence audit, making up 70.7 percent of all audits for fiscal year 2016. Correspondence audits are more like error corrections. The IRS may ask you to mail in support for information reported on your return 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 audits are more comprehensive and tend to be the ones that taxpayers fear. They’re usually held at your place of business or at your accountant’s office. They can involve hours of review and verification by a revenue agent.
However, the IRS 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 a revenue agent’s time for weeks or months on end.
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 to gather the necessary documents, reports and backup. 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, entertainment and travel expenses. IRS auditors look at many returns, so they have a gauge of what income and expenses are typical for different types of businesses. Auditors tend to take a particularly hard look at meals, entertainment and travel expenses because these areas are prone to abuse.
Of course, often there are perfectly legitimate reasons for your unusual expenses and high entertainment and travel expenses, 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 will be in a much better position than those who need to chase down documents and dig through piles of paperwork to procure what the auditor needs.
3. Look for Additional Deductions
If you accidentally forgot to include some revenue on your return or erroneously claimed deductions for which you weren’t eligible, 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 deductions, such as business miles, home office expenses, charitable contributions or expenses that were paid for with a personal PayPal account or credit card.
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 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. 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 other expenses, 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, I’m not being audited, but if the IRS ever decides to audit me, I won’t have to worry about having a significant travel deduction denied.
5. Seek Professional Help
If you feel overwhelmed with the idea of talking to an IRS auditor, it may be a good idea to enlist the help 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 of the requests for documentation. Plus, professionals are experienced at dealing with tax law and auditors.
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 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 by filing an appeal. Your tax pro can help you decide which method is right for you and guide you through the process.
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 he or she chooses. Be honest, reasonable and professional with your auditor, and you should get the same treatment back in return.
about the author
Janet Berry-Johnson, CPA, is a freelance writer with over a decade of experience working on both the tax and audit sides of an accounting firm. She’s passionate about helping people make sense of complicated tax and accounting topics. Her work has appeared in Business Insider, Forbes, and The New York Times, and on LendingTree, Credit Karma, and Discover, among others. You can learn more about her work at jberryjohnson.com.