If you haven't prepared for a personal tax audit, these horror stories may be your wake-up call
How bad can an IRS audit get? Trust us. You really don't want to know firsthand. But we did pose the question to four tax experts whose accounting practices specialize in serving entrepreneurs. Our goal was simple: to identify the biggest personal audit risks business owners face and to suggest ways to minimize them.
The audits you'll read about below really happened. (Some details have been changed to protect confidentiality.) With any luck, you'll never share those experiences--especially if you're prepared.
This auditor is from hell!
"Most IRS auditors are fairly objective people who give taxpayers the opportunity to show that everything was done fairly," says Jeffrey Levine of accounting firm Alkon & Levine PC, based in Newton, Mass. "But a few years ago, one of my clients went through an audit where there was no objectivity at all. The concept was 'Everything here is wrong unless you prove otherwise," he recalls.
Levine's client, who ran a medical-consulting firm, was required by the auditor to document the business purpose of purchases as small as $2.
Fortunately, Levine's client had kept scrupulous records. "But there was nothing rational about the entire process. Even if every contested item had been wrong, it still would have added up to just a few thousand dollars--scarcely enough to justify all that time on the auditor's part. The result was, my client had to spend a lot of time and money proving he was right all along."
Survival Strategy: The best-kept secret about audits is the extent to which their outcome depends on the auditor's personality. That's one reason you should consider putting your accountant in charge: besides being dispassionate, he or she might also be able to ease the process along because of a rapport with the auditor or personal insights about the auditor gleaned from previous cases.
The records don't exist!
"Under the best conditions, the IRS asks for the supporting documentation regarding an item or two on your tax returns, you provide it, and that's that," notes John Evans, the New York Citybased deputy director of the Enterprise Group of international accounting firm Arthur Andersen. "Problems usually arise only when records are missing."
In one case, Evans had a client whose business rented space from a building the client owned. "He had purchased the building many years earlier and had made a series of improvements. The owner had been depreciating the cost of those improvements, which totaled about $90,000, for some time. Then the IRS asked for substantiation. Unfortunately, the owner hadn't kept the receipts for his improvements--he didn't even have proof of the original purchase price of the building."
Ouch. Without any original documentation, the owner and his accounting firm had to build their defense around the "reasonable" nature of claimed deductions. "To do that, we went back and researched the historical sale prices of similar buildings, as well as the cost of similar improvements. We were able to obtain a favorable outcome based on estimates that added up to even more than the amounts we had claimed. But it took some time and work."
Survival Strategy: The good news here is that you and your accountant can defend yourself even if your record keeping is sloppy. But it's a lot simpler and less expensive to simply maintain good records. (See "How Long Is Long Enough?" below.)
The questions seem ridiculous!
There are some likely candidates for an audit. Those include people with family incomes of more than $200,000 or so, self-employed people who file Schedule C returns, those who take large deductions centered on a home-based business, and the owners of S corporations that are getting audited by the IRS. But sometimes people get picked for reasons that defy explanation.
"We had one audit that was absolutely laughable," recalls Ron Silberstein, a certified public accountant with Hirsch & Silberstein, in Farmington Hills, Mich. "Our client was the sole owner of a small company that was structured as an S corporation. The crazy thing here was that she was challenged by the IRS on only two points: charitable contributions and IRA contributions. Why? They were easily substantiated. They totaled less than $2,000. But by the time we finished corresponding with the IRS, she wound up spending $650 in accounting fees."
Survival Strategy: If you're challenged by the IRS, it will cost you--in either accounting fees or your own personal time, and possibly in a negative judgment from the tax man as well. Ask your accounting firm if there's a way to minimize its fees (if nothing else); some firms, like Hirsch & Silberstein, have started offering different types of audit insurance.
The accountant was incompetent!
One all-too-common problem strikes business owners when they outgrow the sophistication of their tax advisers but continue to rely on them for personal and corporate advice all the same. "A business owner once came to us after the damage had been done," recalls Tom Bonadio, whose accounting firm, Bonadio & Co., is based in Rochester, N.Y.
The entrepreneur had received an audit notice from the IRS after selling his company, which he'd done with the assistance of his longtime accountant. "The previous accountant had forgotten to make certain essential tax filings connected with the sale," explains Bonadio. "He had also made serious miscalculations on depreciation matters and other issues. Once his client was hit by the audit, the accountant couldn't handle it--in part because he was so defensive over his errors. So the company came to us."
Bringing matters to a resolution, says Bonadio, was "arduous. It probably took us six to eight months, and at the end, the client did have to write a big check. But the settlement wasn't nearly as big as it once seemed it would be--in large part because the IRS was willing to be reasonable once it saw we were making good-faith efforts."
Survival Strategy: While some audits are unavoidable, you can reduce your chances of being audited--especially over complex business or personal transactions--by relying on the best-quality tax advice you can find. Good sources of leads are your banker, your corporate lawyer, and industry colleagues.
Records: How Long Is Long Enough?
Don't sabotage yourself by discarding personal records too soon.
Here are some guidelines from Hirsch & Silberstein. (Ask your accounting firm for similar guidelines for corporate documentation.)
- Canceled checks, bank-deposit slips, and bank statements: Keep seven years.
- Tax returns: Keep indefinitely.
- Home-improvement records: Keep for ownership period plus seven years.
- Investment records: Keep for ownership period plus seven years.
- Real estate records: Keep indefinitely.
Jill Andresky Fraser is Inc.' s finance editor.
If you, like most of us, fear the IRS's wrath (or even its attention), here's the book for you: What the IRS Doesn't Want You to Know: A CPA Reveals the Tricks of the Trade (Villard Books, 800-726-0600, 1997, $13.95), by Martin Kaplan (the CPA) and Naomi Weiss. It's hard to know what's better about this guide (now in an updated and revised third edition): its seemingly endless tips or its truly delightful style. Who wouldn't appreciate a book with chapter titles like "IRS Targets and What to Do If You're One of Them"? Another especially useful section focuses on the 13 biggest misconceptions people have about their tax returns.
How shrewd is Kaplan's advice? Here's one nugget: the most important step taxpayers can take to reduce their audit risk, he claims, is to "remove as much information as possible from your 1040 to another place where the chances of audit are greatly diminished." How? Check out chapter 8.
ALKON & LEVINE PC, Jeffrey Levine, 29 Crafts St., Newton, MA 02160; 617-969-6630 97
BONADIO & CO., Tom Bonadio, One Cambridge Pl., 1850 Winton Rd. South, Rochester, NY 14618; 716-244-2000 97
JOHN EVANS, Arthur Andersen, 1345 Ave. of the Americas, New York, NY 10105; 212-708-4000 97
HIRSCH & SILBERSTEIN, Ron Silberstein, 31731 Northwestern Hwy., Suite 156W, Farmington Hills, MI 48334-1662; 810-855-4944 63, 97