Who's afraid of being audited by the IRS? Most everyone. The key to surviving an audit -- and even coming out on top -- is not to panic, but to prepare. If you go it alone, before meeting the auditor, thoroughly review the tax returns being audited. Be ready to explain how you or a tax return preparer came up with the figures. If you can't, then head for the preparer or another tax pro. Pinpoint problems backing up income sources or expense deductions. Research tax law, if necessary. You'll need to legally show your right to take tax deductions or other tax benefits claimed on your return.

Find all records that substantiate your tax return. As discussed, the IRS has a right to look at any records used to prepare your tax return. Organize your records for the auditor in a logical fashion.

Neatness counts. Forget about dumping a pile of receipts before an auditor and telling her to go at it. Messy records mean more digging, and more gold the IRS expects to mine. Conversely, auditors frequently reward good recordkeepers by giving these folks the benefit of the doubt if any problems arise. Neatness builds your credibility with the auditor even if you are not really all that honest. Order appeals to an accountant's mentality, I guess. Also, pre-audit organization of receipts, checks and other items refreshes your recollection for the audit meeting.

What to Bring to an Audit of Your Small Business
Be prepared to show that your tax return is based on good business records. Audit success means documenting your expenses. Proof should be in writing, though auditors can accept oral explanations. A list of items the auditor wants to see usually accompanies your audit notice.

At a minimum, the IRS will expect you to produce the following documents:

  • Bank Statements, Canceled Checks and Receipts. The auditor will want to see bank records from all your accounts, both personal and business. As a rule, don't discard any business-related canceled checks, invoices or sales slips. If you paid some expenses with cash, keep the paperwork (handwritten notes, receipts or petty cash vouchers) showing the payments.
  • Electronic Records. Most banks don't return canceled checks anymore, and many business expenses are charged on credit or debit cards. Bank and charge card (Visa, MasterCard, American Express) statements are now accepted by the IRS as proof of payment. They must show the name, date, amount and address of the payee.

    Since charges and statements don't show the business nature of the expense, you can't rely on them as your only records.
  • Books and Records. The auditor will ask to see your "books." The tax code doesn't require small businesses to keep a formal set of books; don't let an auditor tell you otherwise. If you keep records with only a check book and cash register tapes, so be it. If you maintain more formal records such as ledgers and journals the auditor is entitled to see them. If your data is on computer, the auditor will want to see a printout.

NOTE:   Don't make the IRS guess. If you don't produce adequate records, the auditor is legally permitted to estimate your income and/or expenses plus impose a separate penalty for your failure to keep records.

  • Appointment Books, Logs and Diaries. Businesses that offer services typically track activities and expenses using calendars, business diaries, appointment books and logs. An entry in a business diary helps justify an expense to an auditor as long as it appears to be reasonable.

    Additionally, you must keep special records for certain equipment, called "listed property," if used for both business and personal purposes. (IRC § 280F.) Computers kept at home but used for business, cellular phones, and vehicles used for both business and pleasure are designated as listed property. Purely business equipment is not in this category. For example, mechanic's tools, a lathe or a carpet loom are purely business expenses and no records of usage are required. But when assets are put to both business and personal use, the auditor can demand records of usage. For example, if you use a computer for business email and to play solitaire, keep track of the business portion. One way is with a note pad next to the computer.

    If you haven't kept usage records of listed property, reconstruct them by memory or reference to projects that you worked on during the year.
  • Auto Records. As mentioned, a vehicle can be "listed property" if it's used for personal purposes as well as business. So business use of your personal auto requires detailed records showing the work portion. A log is the best way to keep track, but is not strictly required by the tax code. Alternatively, keep all gas and repair receipts in an orderly fashion with notations of trips showing how the car was used for business. A less accurate way to keep records is to add up the gas bills and divide by the number of miles per gallon that your car averages. Show the auditor your auto trip receipts and explain how they link up to sales trips by your business diary or calendar notations.
  • Travel and Entertainment Records. By law, out-of-town business travel and entertainment expenses (T & E, in auditor lingo), require greater recordkeeping than most other expenses.

    You must have a written record of the specific business purpose of the travel or entertainment expense, as well as a receipt for it. (IRC § 267.)

    A good way to document T & E expenses is with an appointment book or log, noting each time you incur a business expense, and the reason. Most folks aren't disciplined enough to write down every expense as it is incurred. It is okay to put together a log or diary after you have received an audit notice. But be up-front about it; don't insult the auditor's intelligence by trying to pass off wet-inked paper as an old record. Remember, it's key to develop and maintain credibility with the auditor.
  • Example 1:
    Bianca, a self-employed designer, reconstructs a calendar book with a notation for June 18, 2000, as follows, "Round-trip cab fare to office of John Johnson, prospective client. $14 (no receipt). Lunch at Circle Restaurant. Discuss proposal to decorate new offices at 333 Pine St. $32 (Visa charge) plus cash tip of $6 (no receipt)." Bianca can also give the auditor details, if asked. The auditor will probably be satisfied if it appears reasonable.

    Example 2:
    Sam (the owner of the computer store, remember) went to an out-of-town computer retailers' convention. He spent $1,800 and claimed it as business travel expenses on his tax return. On audit, Sam produces charge card statements to prove the $1,800 was spent for hotels, meals and convention registration. The auditor wants more and asks Sam to justify the business purpose of this trip. Sam produces an ad for the convention, an agenda of events and notes he took at programs. If it looks legitimate, and Sam's explanation of why it was important for him to be there is convincing, the auditor should allow the deduction in full.

  • Expenses for Renting or Buying Property. To prove business rental expenses, bring in a copy of your lease, or if you own the property or equipment, bring in the purchase contract. This establishes grounds for claiming these expenses as well as a beginning tax basis of the property, if you claim depreciation expenses.