Small Businesses: Surviving an IRS Audit
Small Businesses: Surviving an IRS Audit
It doesn’t matter if you run a consulting firm with $5 million in annual revenue or a street corner hotdog stand that brings in $20,000 a year — an Internal Revenue Service (IRS) audit of your tax returns has the potential to be one of the most financially and emotionally draining experiences you’ll encounter as the owner or operator of a small business.
But with proper planning and a clear understanding of what to expect, you can significantly improve your odds of emerging relatively unscathed.
What the IRS Looks For
While there may be exceptions to the rule, Uncle Sam doesn’t typically initiate audits in order to identify taxpayers who have accidentally handed over too much money to the federal government. IRS auditors are trained to ensure that each filed return reflects the truth, the whole truth, and nothing but the truth about your small business income and tax liability. They are likely to scrutinize business practices and search for filing errors to make sure that you have paid every penny you owe.
Whether the IRS requests a face-to-face meeting or chooses to conduct its audit through correspondence, the following issues may arise:
Unreported income — The IRS will assess taxes on the “missing” amount plus interest and penalty charges – regardless of whether the omission was accidental or intentional. A finding of significant fraud could even result in criminal prosecution and jail time. If you expect to be grilled about unreported income, consider hiring a tax professional to help you through the audit.
Personal expenses vs. business expenses — Be prepared to prove that expenses you’ve claimed for business purposes were not actually personal expenses. Auditors pay particular attention to deductions related to entertainment, meals, travel, and transportation. Keep all receipts and be ready to answer questions about the connection between each expense and your business. If you drive your car for personal and business reasons, maintain a detailed mileage log with a column for each type of use.
Employees vs. independent contractors — If your business employs independent contractors, the IRS will want to make sure that you’re not avoiding payroll taxes on behalf of individuals whom it considers employees. If a worker has a business of his or her own and offers services to other businesses, the contractor designation is likely to hold up. If you tell an individual where, when, and how to work, the IRS may consider that person an employee. Misclassifying a worker could result in taxes, interest, and penalties.
Lifestyle inconsistencies — If you live like a king and file like a pauper, expect the auditor to leave no stone unturned.
The IRS also has a Market Segment Specialization Program (MSSP) designed to train its employees about the intricacies of dozens of specific business niches, ranging from Alaskan commercial fishing to car washes to the scrap metal industry. Fortunately, the MSSPs Audit Technique Guides are available online (www.irs.gov; look under the “Businesses” heading), so you can check to see whether your industry is included in the program. If it is, studying the relevant guide might help you get inside the head of your auditor, so to speak.
How to Prepare
Even if you don’t expect the worst during your audit, there are several reasons its still a good idea to enlist the services of an experienced tax professional to help you navigate the process. For example, a professional is probably more familiar with the complexities of ever-changing tax laws than you, and is also less likely to let emotions cloud his or her judgment. In addition, letting a pro speak on your behalf reduces the chance that you will accidentally volunteer information that could hurt your case.
There are simple steps you can take on your own too. One obvious, but very effective way to make a good first impression during an audit is to have all of your business records organized in a neat and logical manner. Doing so will help refresh your memory about important details, and it just may inspire an auditor to give you the benefit of the doubt in case you cant document a particular claim.
When you’re getting organized, be sure you have the following records:
- receipts and invoices for income and expenses
- bank statements and cancelled checks
- accounting books and ledgers
- computer printouts of data you used in the preparation of your return
- leases and/or titles for business property
How Long Should You Keep Tax Records?
In general, the IRS advises taxpayers to keep all tax records for at least three years. In some cases, however, the recommended time period is longer. For example, any records related to bad-debt deductions or worthless-securities deductions should be kept for seven years.
Of course, if you didn’t file a return in the past, or if you filed a fraudulent return, there is no limit on how far back the IRS can go in its quest to get paid. Before you throw any records away, always check the applicable statute of limitations in the state where you file to make sure that your old returns are not still subject to examination by local tax authorities.
For more information, read IRS Publication 583 (Starting a Business and Keeping Records).
Your Right to Appeal
Of course, being prepared for an audit doesn’t guarantee that an auditor will rule in your favor. The first step in the appeal process typically involves requesting a meeting with the auditor’s supervisor in order to review your case and explain why you think the auditor’s conclusions were unfair or incorrect. If that doesn’t solve the problem, you then have the right to schedule an appeals conference, in which you may represent yourself or hire a lawyer, certified public accountant, or other professional to state your case. If that meeting does not produce the results you’d hoped for, you have the right to take your appeal to court.
Keep in mind that interest and penalties imposed during the audit will continue to compound during the appeal. Also, an appeals officer may raise issues that hadn’t come up before, so you run the risk of opening a whole new can of worms with each additional interaction you have with the IRS.
Before deciding whether you should appeal the results of an audit, read IRS Publication 5 (Appeal Rights and Preparation of Protest for Unagreed Cases), Publication 556 (Examination of Returns, Appeal Rights and Claims for Refund), and Publication 1660 (Collection Appeal Rights). The publications are free and available online (www.irs.gov) or by calling 1.800.829.3676
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