How to Survive a Tax Audit
If you're prepared, honest and organized, an audit isn't as scary as you might think.
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If you think there's nothing more frightening than getting a letter from the IRS, you're not alone, especially these days.
In 2005, the IRS estimated the difference between the amount of tax money that is paid each year and the amount of tax money that should be paid, also known as the tax gap. The figure they came up with was $345 billion annually, and their concerted efforts to close that tax gap by conducting audits has left small business owners shaking in their boots ever since.
The tax gap has been attributed to three main categories of filing errors: failure to file altogether, underpayment of taxes owed and underreporting of income. The latter error is the one the IRS attributes the most to self-employed individuals and small business owners, because it's incumbent upon them to report every payment they receive to the IRS.
"The tax gap is still a major focus of the IRS and Congress," says Abe Schneier, a Washington D.C.-based senior technical manager at the American Institute of CPAs. "They want to try to find a way to deal with specific small business issues."
It may be too late for you to prevent being audited for previously-filed tax returns, but it's never too late to prepare your records should the IRS come a-knocking. Plus, the more organized your records are, the less likely you are to make the kind of simple filing mistakes that may trigger an audit.
This guide will educate you on the different types of audits there are and how to prepare yourself for a face-to-face field audit.
How to Survive a Tax Audit: Types of Audits
"You either get picked for a paper audit or an in-person audit," says Kelly Phillips Erb, a Philadelphia-based tax attorney with Erb Law, who has not only represented business owners during an audit, but who has also been audited herself. She says a paper audit typically only occurs if you have made a minor error that can easily be fixed with additional documentation or payment. It's usually triggered by some discrepancy between the information you filed on your return and other information from banks and past returns that the IRS has on file for you. Fortunately, this type of correspondence from the IRS is easily cleared up if you can provide the necessary documentation on a particular expense or deduction.
Unfortunately, the most common type of audit that small businesses face is the field audit, in which you actually meet with an IRS agent. This can occur either at the IRS office or at your place of business, but, Schneier, says, "Typically they'll want to visit your place of business at least once."
You will receive notice of a field audit through the mail, never by e-mail. If you receive an e-mail notice, it's a scam and you should contact the IRS immediately. The paper letter will provide you with a date by which you must contact the IRS to schedule an audit appointment. The letter will also assign you an IRS agent and list the documents the IRS wants you to produce. Even if you don't have all of the documents in order by the date they request, do contact the IRS office before the deadline. Waiting too long to respond may arouse suspicion that you have something to hide. John Baiardi, a New York-based tax-managing partner with the accounting firm Mitchell & Titus says, "The worst situation you can be in is if they ask you for something, and the request sits on your desk for a long time. That puts you on the defensive."
When you call the IRS office, a representative will ask you to choose an actual appointment time most likely several weeks in advance, giving you ample time to get prepared.
During a field audit, you will meet with an agent once or twice, unless you fail to produce the necessary documents and prolong the process. "They're under production timing," says Schneier, "and they like to close out cases as efficiently as possible."
The preparation section below will help you make sure the audit goes smoothly.
Dig Deeper: Avoid an Audit
How to Survive a Tax Audit: Common Triggers for an Audit
There are countless reasons you may be chosen for an IRS audit. Typically, the only time the selection is random, however, is if your tax return is entered into the IRS's National Research Program. This program enables the IRS to study the taxpaying habits of a cross section of the country. You may not have made any mistakes if you are chosen for this reason, but the audit will not be any less thorough.
The IRS also runs several checks through computer systems, in which they compare your return to W-2s, 1099s and other bank information. If an error is detected, the IRS has three years from the date the return was due to conduct an audit.
One test the IRS runs is the Discriminant Inventory Function System (DIF). The system assigns points for every error you accrue. Once you reach a certain error score, you're eligible for audit, and, according to the IRS, "the potential is high that an examination of your return will result in a change to your income tax liability."
It's not just outright errors and miscalculations that can alert the IRS to an incorrect return filing. They may also be curious about charitable donations, depreciation deductions, dependent exemptions, business expenses, and more. In some cases, a third-party informant will tip off the IRS.
Dig Deeper: IRS Targets Small Businesses
How to Survive a Tax Audit: Preparation
If you are being audited, there's not much else you can do but get organized. "Don't just hand over a pile of papers to the agent and say, 'Here, find what you need,'" Erb warns. "You don't want the IRS poring over your financials any longer than they have to."
Though the IRS will give you a detailed list of what they want to see, you'll want to have your other records at hand should they request it. Here's a checklist of what documents you may need. In most cases, you should have at least three-years worth of this paperwork available, since, as mentioned above, you are eligible for audit within three years of the date the return is filed.
