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."

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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.

  • Bank statements
  • Canceled checks
  • Receipts for charitable donations, business expenses and items sold at a gain
  • Electronic records
  • Payroll books
  • Appointment logs
  • Automobile records (if your automobile pertains to your business)
  • Travel and entertainment records
  • Mortgage statements
  • W-2 forms
  • 1099 forms
  • Articles of incorporation
  • Minute books
  • Loan records

Organize the records by category and by date, so the auditor can quickly and efficiently find the information he or she needs. If you can't find a document by the designated appointment time, Erb says it's all right to call the IRS office and ask for an extension. "In terms of timing, if you're being cooperative and forthright most agents will extend the time you have to provide things, if you ask," she says.

Most documents you need can be requested from your bank or from the government itself. If you absolutely can't find a document, Erb says, sometimes you need to "face the consequences," which is why it's important to start being a tedious record keeper before the IRS comes calling.

Dig Deeper: Preparing for an Audit

How to Survive a Tax Audit: During the Audit

When you meet with the auditor, you're entitled to have representation with you. Baiardi encourages all business owners to consult a tax professional, because you need to make sure you're answering only the questions the auditor asks and nothing more.

Schneier agrees: "Answer the questions, but don't offer information you don't have to offer. Be straightforward about it, but don't manufacture excuses. The agent really doesn't care."

It's wise to keep quiet for the most part. Erb knows all too well how frustrating it can be to be interrogated about your business, but she says, "Keep in mind if they're asking you lots of questions, that's not a bad thing. They're giving you the opportunity to prove them wrong."

If, however, you (and your advisor) feel that the auditor's line of questioning is not relevant to the initial issue they were sent to investigate, Schneier says it's okay to speak with the agent's supervisor.

The IRS does allow you to make an audio recording of the audit examinations. If you choose to do this, you must give the IRS agent a written notice 10 days before your appointment, stating that you will be recording the meeting.

Remember, the most important thing is to prove is that there was no clear intent on your part to defraud the government. "Most of the time people are not willfully not paying taxes," Erb says. "Being sloppy about filing doesn't mean you're not going to get a penalty, but it means you might not get charged with intent to evade taxes."

Dig Deeper: Audit Survival Tips

How to Survive a Tax Audit: After the Audit

The auditor will issue your examination report, listing any penalties you owe with the interest rate built into the cost. In some cases, the auditor will decide there is no change to your return. If you agree with the report, you can sign and pay whatever you owe, ending the audit process right there.

If, for some reason, you do not agree with the report, you are entitled to an appeal. Your agent will send you a letter explaining your right to appeal, and you must respond to the letter with your decision no later than 30 days after you receive it.

Though appealing a penalty may be your initial impulse, Erb says it's important to remember that the cost of an appeal may be comparable to the penalties you owe. "Most of the time people make a lot of noise about appeals, but it's very rare that they actually do it," she says.

If you're not able to pay the penalty, some businesses may be eligible for an offer in compromise (OIC), which, according to IRS, is "an agreement between a taxpayer and the Internal Revenue Service that settles the taxpayer's tax liabilities for less than the full amount owed." This payment may be made in installments or an adjusted lump sum. The IRS will only accept your OIC, however, if they believe the amount you offer to pay is equal to the amount you're able to pay, also known as your "reasonable collection potential." Find additional details about OICs here.

After the audit process is settled, Schneier says, "It's likely the IRS will review your subsequent returns to make sure you don't fall into the same pattern again." In other words, if you've been audited once, you're more likely to be audited again, so it's important to pinpoint the mistakes you made that raised the red flag to the IRS in the first place.

Erb says if the error was made by a third-party tax professional, it's wise to seek tax advice elsewhere. In fact, she says, "Having a crappy accountant can be a reason to have some penalties abated." Make sure you reassess the accounting software you use, and be more attentive to recordkeeping.

"If you're running a business successfully, getting audited is not the end of the world," Erb says, noting that it may actually help you improve your business operations. "You have to identify what was the thing that got me in trouble, and how do I make sure that thing doesn't happen again?"

Dig Deeper: Tax FAQs

How to Survive a Tax Audit: Resources

For the IRS's step-by-step explanation of the audit process, click here.

Find an explanation of the tax gap here.

Check out Erb's TaxGirl blog here.

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