High on the list of issues no business wants is a tax audit. No matter how scrupulously you run your business, a tax audit has the potential to strike fear. Keep in mind that for the majority of business owners, a tax audit is a nuisance and nothing more. However, it is a nuisance for which you must be prepared.
Whether or not you have been approached by an auditor, it’s wise to have a proactive plan in place. Even the potential for an audit may seem overwhelming. If the IRS has notified you that an audit is pending, having a plan will make the process less painful—and you’ll probably sleep easier, too.
Why would the IRS audit my business?
Don’t panic just because you’ve received notice that the IRS is auditing your business. IRS methods for audit selection do not necessarily indicate a problem. You may have received an IRS audit due to:
- Random sampling – Some tax returns are audited based simply on a statistical formula. If your business return comes up during this random sampling, there’s no reason to think anything is wrong. The IRS compares random samples against norms as part of its National Research Program.
- Returns with issues, or other examinations based on transactions –The IRS may audit your business because it found an issue with your return. If a business partner or investor is audited, that increases the likelihood of your return’s examination.
Scenarios that can trigger audits:
- High income returns
- Unreported 1099 income, or misclassifying employees
- Unreported alimony or property settlements
- Excessive business deductions (home office, mileage, meals/entertainment)
- Repeated business losses
- Large cash purchases
As your business’ gross receipts and income grows, so does your audit risk.
The IRS uses the Information Returns Processing System (IRPS), which receives data submitted by employers and third-parties reporting taxpayer income. The information reported is matched to the documents received.
How do audits work?
There are three ways in which the IRS conducts audits:
- Mail – Mail audits request additional information about tax return items. These generally refer to income, expenses, and itemized deductions. These audits are limited to the items on the IRS audit letter.
- Office audit – The office audit takes place at an IRS office. Along with providing documentation, expect to answer detailed questions about your business’s finances. Office and field audits usually take place when the auditor wants to examine more records than it would be reasonable to mail.
- Field audit – The field audit takes place at your place of business or at home, or at your accountant’s office. The majority of IRS audits are field audits. If the audit takes place at your business, you must provide the auditor with an onsite work location. Customers and employees should not be able to view this space.
For office and field audits, you should have an enrolled agent or other tax professional on hand.
The audit process starts with business owner notification. The IRS always notifies a taxpayer or business for an audit via mail. It will never begin the audit process with a telephone call.
The audit process per se is relatively straightforward. Gather the documents requested by the IRS and submit them to the IRS by the deadline on the notice. The IRS permits submission of certain electronic records if produced by tax software. After reviewing your response, the IRS issues a determination.
As always, the devil is in the details. If your recordkeeping is in order, odds are the audit process will proceed smoothly. If your recordkeeping is less than stellar, the audit may prove more difficult.
How to best prepare for an audit
Start preparing for an audit before you receive IRS notification. Conduct your business as if an audit is expected. In other words, document, document, document. Although an audit isn’t a pleasant experience, if your paperwork is in order and your recordkeeping is good, you should not have to worry.
Here are the basics:
- Keep your finances organized
- Maintain accurate records all throughout the year
- Clearly separate business and personal transactions
- Keep supporting documents for your claimed deductions
Where to start if you’re being audited
What’s the best way for a business to respond after receiving a notification? Get started by taking these three initial steps:
- Review your audit notice carefully.
- Gather the requested information. If mailing information to the IRS, always request confirmation of receipt from the delivery service used.
- If needed, seek support from an accountant or representation from a tax attorney.
Documents and records
What documents and records are needed for a tax audit? The IRS may require documents that support the income, credits, and deductions claimed on your business tax return. Since these are documents used to create your return, there is no need for the production of new documentation.
The IRS may send you a written request for specific documents. Your IRS notice informs you how and when to present these records. Bring the records with you for in-person audits. For mail audits, send them to the address on the notice.
Such document and records may include:
- Bank statements
- Receipts from received payments and for amounts received by your business, including reimbursements
- Bookkeeping records (not required by law, but helpful if you have them)
- Legal papers
- Loan agreements
- Travel logs, tickets
- Service records, such as appointment calendars
- Schedule K-1 for shareholders and partners
- Others including theft/loss documents
Possible audit outcomes
There are three IRS audit conclusions. In a best-case scenario, the auditor verifies that the information you have provided is substantiated and correct. That’s the “no change” conclusion.
The IRS may propose changes to which you agree. Agree with the findings and sign an IRS examination report or a similar form. If you owe money, the IRS offers several payment options.
You may also disagree with the proposed changes. There are processes available for disputing these changes.
If the auditor determines the information provided is incorrect, your business may be subject to additional tax, along with fines, fees, and interest.
If the IRS discovers evidence of tax evasion or fraud, such additional taxes, fines, fees and interest are usually very high. In a worst-case scenario, those evading taxes or filing fraudulent returns can end up in jail. However, that’s an extremely unlikely outcome for a garden-variety tax audit.
There’s also the possibility you may receive a tax refund if it turns out you have overpaid your taxes.
What you can do
If you do not agree with the auditor’s decision regarding the amount of tax you owe, ask to speak with their manager. Sometimes, discussing the matter with a higher-up can resolve the issue.
You can request mediation, also known as an Alternative Dispute Resolution (ADR). An appeals officer works with you and the IRS auditor assigned to your case. Mediation is voluntary and nonbinding. It is most effective when both parties want to resolve the issue in dispute. ADR is best used when all other issues are completely resolved. It is not an opportunity to buy time with the IRS or a replacement for the audit or collection process.
If those options do not work, there is an appeal process. The appeal process is meant as a method for resolving the dispute without taking your case to court. The IRS notifies taxpayers about their right to appeal a dispute, but you can request an appeal on your own. You must appeal within 30 days of receiving the IRS letter. It’s colloquially known as a 30-day letter.
If the amount of additional taxes or penalties is under $25,000, you may qualify for a small case request. Partnerships and S corporations are ineligible for small case requests. Send a brief written statement requesting an appeals conference. In this statement, indicate the changes with which you do not agree and provide the reasons you do not agree with these changes.
If the total is over $25,000, you must appeal via a formal written protest. A written protest must include why you disagree with the decision and support for your opinion. Such support may include legal or regulatory evidence.
An IRS appeals officer meets with you in person or by phone. Such discussion may also take place by mail. While you do not need your accountant or tax attorney with you, it helps to have professional expertise.
Keep in mind you cannot introduce new documentation during your appeal. Doing so means the IRS auditor takes your case back for further consideration.
If you disagree with the appeal’s results, you still have the right to take your case to court. Determine how much that may cost you in legal fees before going that route.