It is routine practice for the Internal Revenue Service (IRS) to perform audits. While an IRS audit typically carries a negative connotation, designation for an audit is not a steadfast indicator of any wrongdoing.
In fact, the IRS selects audits based on random statistical formulas which analyze a tax return and compare it to other similar returns. You can breathe a little easier knowing that of the 196 million returns filed for calendar year 2016 only 1.1 million, or 0.5%, of those returns were audited. On top of that, only 1-2% of businesses are audited each year.
While the chance of an audit is fairly minimal, they do still happen. To help you prepare for an IRS audit, we outline some of the triggers that make an audit more likely and offer some tips on how to handle an IRS audit should it happen.
Audit Preparation: IRS Audit Triggers
The reality is that an IRS audit of your business is very unlikely. However, there are certain actions that can increase the likelihood of an audit. These red flags include:
- Using Round Numbers
- Failure to Report Corporate Employee Salaries
- High Meal and Entertainment Deductions
- High Home Office Deductions
- Claiming Your Vehicle as 100% Business Use – See our article about Section 179 vehicle deductions for more information
- Claiming Business Losses for Several Years
- Reporting Higher Income – This is not something to avoid. Just be aware that reporting a higher business income generally elevates your risk of an audit.
Keep in mind that this is not a full, comprehensive list of every alarm bell for the IRS. Also, these actions do not mean an audit is imminent. As noted above, the audit selection process involves analytical formulas and comparison procedures. However, we think it is important to keep you aware of certain actions that can increase the likelihood of receiving the dreaded notification from the IRS.
Other Focus Areas for IRS Audits
The IRS does pay special attention to certain types of businesses and activities. For example:
- Cash businesses – It is inherently easier to under-report income; therefore these businesses are more likely to undergo an audit. In these cases, it is difficult to prove income.
- Business travel, meals and entertainment – These expenses are top targets for IRS auditors. It is important to include the date, time, amount, who was there and specific business purposes.
What to Expect if Your Business is Audited
Even if you take all of the precautionary steps, you can still receive an IRS audit notification. Some important information to keep in mind:
Three Types of Audits
- Correspondence audits – The IRS conducts the audit via letter. They typically ask for verification, error correction or additional documentation.
- Office audits – These audits are becoming less common. An office audit involves a taxpayer delivering specific documents to an IRS office.
- Field audits – The most comprehensive of the types, a field audit includes the IRS physically coming to your business. They can request any forms, documents or previous years’ tax returns within designated limits.
A field audit is the most common type of audit. The IRS often consider all aspects of the business and its owner(s). They extensively assess the business records and accounting systems, while also performing tests to determine the accuracy of income.
Limits on Audits and Collections
Know your rights and know what can and cannot be collected. The IRS has the ability to audit any business or personal tax return within three years of filing. Also, it can collect back taxes owed for up to 10 years. For example, if a 2019 audit of a return filed in 2016 discovers discrepancies in a return or returns filed between 2009 and 2019, it can collect taxes on all of those returns.
There are exceptions to the limits on audits and collections. These can be made for tax evasion, filing a false return or even filing no return at all. Internal Revenue Code Section 6501 lists more information on other exceptions.
How to Prepare for Your Audit
Audits can be complicated, arduous and long-lasting. The average business audit requires an entire year to complete. However, being well prepared can help significantly. We have compiled some of our best tips to help you through the process.
Audit Preparation Tip #1: Consult with a Tax Professional
The first order of business when you receive the IRS audit notification is to consult with, or hire, a licensed tax professional. Ideally, you should look for an enrolled agent, a certified public accountant (CPA) or an attorney. Professionals with these specific credentials are permitted to represent you before the IRS. Even if you prefer to handle matters on your own, it is highly recommended to at least consult with a tax representative.
A simple letter from the IRS requesting specific documentation can signal potential issues ahead. It is best to review the request and other IRS correspondence with someone who has the capacity to help you craft a response.
Furthermore, it is beneficial to have your tax preparer and bookkeeper present during the process. They are able to answer questions quickly and thereby expedite the audit process.
Audit Preparation Tip #2: Find an Appropriate Audit Technique Guide (ATG)
The IRS utilizes ATGs as a means of preparing for audits for businesses in all kinds of unique industries. The guides provide intel into various industries or issues, accounting methods typically used, how income is received and areas where taxpayers may not be in compliance. Typically, ATGs target specific industries or businesses. For example, ATGs exist for construction, aerospace, art galleries, child care providers and veterinary medicine. Other guides address issues that frequently arise during an audit, such as executive compensation, passive activity losses and capitalization of tangible property.
Your business has access to the same information and can use it to gain insight into what the IRS is looking for in regards to compliance with laws and regulations. ATGs are intended to help IRS examiners discern common methods of hiding income and deflating deductions. However, your business can take the same information to ensure that you are not engaging in any practices that raise red flags.
For a complete list of ATGs, visit the IRS website.
Audit Preparation Tip #3: Get Your Records in Order
Poor records can lead to penalties. Thus, pristine organization is vital in the audit process. You should have documentation for the income, losses, expenses and deductions claimed on your tax return. Organize these records by year and by type (income, expenses, pension plans, etc.) and make all relevant records accessible. You should also gather bank or credit card records and information from vendors, if applicable. If the records are not available do not make them up!
Furthermore, make every effort to reconstruct lost or destroyed records, and document your work doing so. For example, if your office experienced a fire or flood that damaged your business records, document your attempts to reconstruct those files.
Also, comb through your records to ensure you do not have any personal expenses in your business records. It is critical to keep personal and business expenses separate. To do this, make sure you are using different bank accounts and credit cards and separating business and personal travel expenses.
Audit Preparation Tip #4: Understand Intentional vs. Unintentional Failures
Taking intentional and deliberate action to minimize your business taxes by illegal means is tax evasion and highly illegal. However, if you can demonstrate that your particular issues (no records for a particular year, for instance) were unintentional, the IRS grants some grace. On the other hand, intentional actions and omissions lead to the imposition of fines and penalties.
Audit Preparation Tip #5: Be Prompt and Prepared
The IRS notifies you well in advance of your audit date and informs you of the year in question. This allows you ample time to diligently gather and organize your records. It is also a good idea to isolate the year in question and have those accounting records easily accessible for your auditor.
Showing a degree of preparedness and professionalism can go a long way in your audit process – as well as speed it up. This can be achieved without costing you anything. It is free for you to be courteous, arrive to appointments on time, dress professionally and promptly respond to requests for information and documents.
You do not have to go through an audit alone. Squar Milner is comprised of hardworking tax professionals ready to guide you and your business through the process. Our experienced employees are CPAs, lawyers and enrolled agents ready to advocate for you. Reach out to us today if you need help with your IRS audit preparation.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.