Small Business

Preparing for an IRS Audit

How small business owners can prepare for - and survive - a tax audit from the IRS.

Nothing strikes fear in the heart of a small business owner quite like receiving a notification of an IRS tax audit. However, by following some basic advice and taking steps to avoid being audited in the first place, the audit process can be completed in a smooth, efficient manner.

How Small Businesses are Chosen for Audits

Matthew J. Anderson, senior accountant at Anderson & Company PC in Bridgewater, says that, for the most part, tax audits of small businesses are typically conducted if there’s reason for the IRS to think the employer isn’t reporting all of its income. “Electronic filing has made it much easier for the IRS to collect data and analyze inconsistencies,” he explains. However, in some cases, audits are initiated on a random basis, although it’s typically more common for random audits to be done on larger businesses, he notes. “There is usually good reason a particular return is flagged for an audit,” he adds.

According to Paula Ferreira, a partner with Mazars USA, LLP, those reasons may include a business reporting losses, volatility in business accounts, or significant swings in income from year to year. “Small business owners need to realize that everything is computerized … and the system will automatically flag all of these types of things as questionable,” she says.

The same holds true when an employer makes a mistake when filling out or filing their tax return. “Most small business owners are honest, but errors do occur,” confirms Joseph R. Doren, partner at PKF O’Connor Davies, LLP in Cranford. “An innocent mistake could trigger an audit … and then who knows what else the IRS may find.”

According to Doren, there are also certain businesses that the IRS may monitor a bit more closely. These tend to be cash-intensive businesses like car washes, laundromats, or convenience stores. “These are businesses that are always on the IRS’s radar, and as an employer, you have to be especially careful when it comes to filing your tax returns,” he warns.

Regardless of the type of business, an audit can also be triggered by someone else … such as a disgruntled employee. “All it takes is one phone call to the IRS from an employee who is accusing you of under-reporting your income,” he adds. “The IRS will pursue these kinds of claims, and if you’re depositing income into your accounts that isn’t claimed on your returns, then you’re really asking for trouble,” Doren says.

Maria T. Rollins, managing partner at KRS CPAs in Paramus, notes that how small businesses are filing can also have an impact on whether or not they receive an audit notice. “There’s a theory that sole proprietors filing a Schedule C are audited more frequently than S or C corporations, and there may be some validity to that,” she explains.

Avoiding an Audit

Though there’s always a chance your business could be chosen randomly, an audit is still more likely to be triggered by an error. According to Ferreira, the most common mistakes that business owners make that could lead to an audit have to do with how expenses are reported or substantiated, making sure that items are properly categorized, or if the percentage of expenses versus income isn’t matching up. “In almost all situations, the tax auditor is looking at deductions to confirm that they are legitimate business expenses,” she says. In particular, auditors tend to investigate both automotive- and entertainment-related expenses.

“If you had a meeting over dinner and you’re deducting that meal as a business expense, then you better be able to substantiate that the sole purpose of the meal was business,” Doren adds. “That’s where keeping good records comes into play.”

While Ferreira notes that it’s impossible to avoid some potential audit triggers, it’s important for small business owners to remain as consistent as possible when filing each year. “You might not be able to avoid a change in your suppliers or margins, but you can control how consistent you are in your reporting – such as where you record expenses and making sure classifications are consistent year to year,” she explains.

The IRS routinely conducts audits of businesses that hire independent contractors because of the tax savings associated with hiring contractors instead of employees, and Anderson notes that when businesses don’t seem to understand the difference between subcontractors and employees, it can raise IRS suspicions. Issues can also arise when a small business owner fails to pay its estimated tax payments, or doesn’t fully understand federal and state payroll taxes and how they affects the business. Small business owners should also be aware that reporting a loss every year could ultimately lead to an audit. “Complete your taxes on time and accurately, and do not try to take deductions that you are not entitled to,” he warns. “You do not want to cut corners with the IRS; it will only create more problems down the road.”

Ultimately, sometimes it’s the simplest of mistakes that can put a small business in hot water with the IRS. “You have to make sure the basics are correct and recorded properly, like your tax ID or social security number,” Rollins says.

Many small business owners may not be aware that an audit is also an opportunity to submit documentation for expenses that weren’t previously claimed on their tax returns. If an employer later discovers they forgot to document certain deductions, they may be able to claim them at the time of an audit and possibly offset any deficiencies that are determined by the IRS.

The IRS allows for third-party documentation, oral testimony and other forms of verification when it comes to substantiating expenses, so small business owners may utilize records from clients and past invoices to substantiate deductions such as business mileage. Businesses that are missing certain receipts or documentation need to take the time to retrieve bank records or credit card statements, or contact their vendors to request proof of payment.

“As a small business owner, it’s your responsibility to be ready for an audit long before that notice is received,” Rollins says. “You can have the perfect accounting system, but what the IRS wants is substantiation … and you don’t want to be scrambling around to find receipts or invoices from vendors at the time of an audit.”

Preparing for an Audit

For small businesses that receive the letter that they’ve been chosen for an audit, the first step is easy – contact your tax professional. “My advice to small business owners is don’t attempt to go it alone,” Rollins says. “Though it’s ultimately the responsibility of the business owner, your accountant probably has pretty good documentation of your paperwork and records, and we have a better handle on tax law and the flow of forms.”

Business owners can request not to communicate directly with the IRS without their tax professional being present, and they can also grant their CPA power of attorney to coordinate with the auditor and complete the audit on their behalf. “Our approach is always to create a clean audit trail and get our clients through the process as quickly as possible,” she adds. “We know how to package the information the auditor is seeking in an efficient manner to get to the best conclusion for everyone.”

Doren agrees: “We’re made it our practice over the years to explain to clients that you really don’t want to be the one to deal with the IRS. You want a professional working on your behalf.” The IRS is currently required to make at least one visit to the place of business, but the audit can be conducted at the accountant’s office. “You want to limit discussion with the auditor, and you definitely want your accountant or some other professional present when you’re being visited by the IRS,” he adds.

When a small business is selected for an audit, they will receive notification in the mail – never by phone or email – and the IRS will request the records that are in question. “Whether you’re being audited randomly or there’s a specific reason, you have to be organized and start pulling records quickly … and having a good relationship with an advisor really does go a long way when it comes to closing that audit quickly,” Ferreira adds. She advises business owners to be forthcoming with the documentation that’s being requested, but to provide only the information that the auditor is seeking.

“You want to conduct the audit in an honest, truthful and civil manner. The IRS auditor is doing his or her job just like you do your job, and most auditors are reasonable people,” Doren concludes. “It’s rare that a small business owner will walk away from an audit with a ‘no change,’ but whether it was an innocent mistake or not, as long as it’s not a pattern, then the auditor probably won’t make a major issue out of it.”

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