When you receive a notice from the IRS that your business financial records are due for an audit, it can be a little daunting. It needn’t be, especially, if you have taken every step to be prepared for the audit, and if you know what to expect during the audit. As long as the IRS doesn’t find any reason to dig deeper into your returns – i.e. as long as they find everything is by the book – you can definitely survive the audit with your business and self-esteem intact.
But first things first, you need to make sure everything is above board before the IRS does. So, what are the things you should do to prep for an IRS business audit?
1. Don’t go at it alone! Hire a tax pro or preparer to help you understand and finalize the numbers on your financials. Be completely clear on every aspect of your financials; if there are any discrepancies on your part, the IRS will dig deeper.
2. Locate and ensure you have records that corroborate every item on your tax return. Sort all these records – receipts, checks, ledgers – in a way that will be easy for both the auditor to understand and peruse. It will also make things easier on you when you’re needed to explain any item on your return.
3. Be organized in keeping track of your records. Not only will it leave a good impression on the auditor, it will also make it easier for them to do their job. Remember, they’re human, as well, and a lack of organization on your part could result in a messy audit, especially when they’re unable to find what they’re looking for. That, in turn, could cause them to dig deeper and you could find yourself one step short of being slapped with a tax penalty.
4. Educate yourself. Research tax law or hire a tax expert to bring you up to scratch on your own rights. You are entitled to claim deductions and benefits; understand exactly where you can exercise those claims – with the requisite laws to back you up – even if the IRS auditor tries to tell you differently.
5. Don’t force the IRS to guess or estimate any expenses that you’re unable to substantiate. That, almost always, ends up in a hefty tax fine. To reiterate: be organized. Here’s a list of records or documents that the IRS will generally request during your audit.
- Checks, Receipts and Bank Statements: This includes bank statements from your personal and business accounts, invoices and sales orders, cancelled checks and receipts, and any paperwork that substantiates direct cash transactions like cash vouchers or notes.
- Electronic and online records: Credit card statements with the name, date, amount and address of the payee are accepted by the IRS. It should be noted, however, that credit card statements don’t often specify the business nature of the transaction made. So, ensure that you have other corroborating records, as well.
- Books and ledgers: The IRS auditor is entitled to audit your books. However, if you’re a small business that doesn’t keep a book, you’re not required to produce one, even if the auditor demands it. But, you should have a formal record of your finances for the auditor to look at, like checkbooks, ledgers, journals, or data printouts, if you record your finances on a computer.
- Property lease or contract if your business leases or has bought property.
- Listed property records: “Listed property” includes items that are used for both business and personal use. In such cases, you should bring any records that substantiate when or how those properties were used for business. For instance, a vehicle that is used for both personal and business transport should have records such as travel logs or gas receipts for when it was used for business.
- Travel and entertainment records: When it comes to recording travel and entertainment expenses, the IRS has specific requirements. Ensure that you have written records and receipts for every specific purpose for the travel or entertainment expense; a good way to do that is to keep a diligent log to record every business expense, the time and the reason for the expense.
Know What to Expect
So, now that you have all your ducks – I mean, records – in a row, what exactly can you expect the IRS to look into?
Does your lifestyle match your specified income?
Let’s say that your return specifies a substantial number of deductions and a little income, but your lifestyle – your home furnishings, your belongings, or your appearance – completely belies that claim; it’ll raise some eyebrows.
Did you falsely misrepresent personal entertainment expenses as business expenses?
Remember, the IRS agents are trained to be naturally suspicious. So, if your return claims a fair amount of travel and entertainment expenses, they will investigate. Remember, when we told you to keep your T&E records transparent? Yeah, this is why.
What are your miscellaneous expenses?
A general – and wise – rule is to simply avoid claiming any expense as “miscellaneous”. The more transparent your expenses are, the easier it will be. But, if your return includes a fair amount for “miscellaneous expense” claims, the IRS will want to know more. They might suspect you have something to hide or that you’re simply just bad at keeping records: more likely the former, because that’s what they’re generally trained to think.
Does your business handle a lot of cash?
If it does, the IRS auditor might be inclined to suspect you of skimming or directing cash into your own pocket instead of the business without declaring it.
False business auto expenses:
If your claim includes a lot of business-related auto expenses, the auditor might suspect you’re trying to pawn your personal trips off as business expenditure. So, make sure you have the travel logs and proof to back up all your auto expenditure claims.
Did you report all of your business income, or did you leave something out?
If the IRS suspects that you have deliberately – and not simply forgotten – left out certain items, well, that’s tax fraud. Essentially, you’ll be in deep trouble. If you do find yourself in such a situation, the best course of action is to hire a tax attorney immediately and remove yourself from the audit process.
Does your payroll tax match the number of reported employees?
Checking the payroll tax claims is a routine part of the tax audit, so make sure your payroll taxes are in order.
Do you really use “independent contractors”, or are you avoiding payroll tax?
Some businesses try to sidestep the payroll tax through this means, and therefore, the IRS will tend to dig deep to sniff such a possibility out. So, be prepared for serious questions about all the employees in your company, and again, with proper records to back all your claims up.
In conclusion, and this cannot be said enough: as long as you are organized in keeping records for every single claim made on your return, there’s no reason why you should end up being embarrassed by the IRS. And, to be on the absolute safe side, hire a tax professional who can have your back during the audit.