The IRS collected $7.3 billion from audits in 2015. Small businesses (sole proprietorships in particular) are more likely to be targeted than bigger companies. But the experience doesn’t have to be painful.
“Believe it or not, an audit is a great learning experience,” says Abby Eisenkraft, a New York-based IRS enrolled agent and tax advisor specializing in small businesses. Audited companies tend to emerge with more proper and organized records, she says.
Certain steps can help small businesses avoid the
anxiety of an audit and the fees they might incur:
1. Make sure you ask why.
“Very few audits are random,” says Eisenkraft. “Generally speaking, there is a reason you were chosen.” The IRS notice typically indicates why they’re asking for certain info. Be sure to understand why.
2. Get help.
Don’t contact the IRS on your own, cautions Eisenkraft, particularly if you have data supporting a claim that contradicts the auditor. A lawyer or other professional experienced in audit representation may be necessary to steer you in the right direction. “If a CPA prepared the return for the period of audit, I would start there,” she says.
3. Build your case.
Gather receipts, logs, and other data that supports the information in your returns. Expense reports draw particular scrutiny from auditors, and you will need receipts – not credit card statements – to back up those claims. Expenses that can’t be justified by a business will be disallowed, says Larry Chester, owner of CFO Interventions, a financial consultancy for SMBs in Wheeling, Ill. The mistake could result in a large bill for back taxes, including interest, he says, and the auditor may decide to explore taxes in other periods surrounding the one in question.
4. Review your file.
The U.S. tax code draws a line between what is and isn’t a legitimate deduction or expense. “But that line is pretty fuzzy,” says Chester. “Many of those are open to interpretation by the IRS agent.” This step could include reviewing the federal requirements for your type of business. Small business owners may want to ensure their quarterly estimated reports, self-employment tax payments, classification of contractors, and other obligations were handled properly.
Segregate any business expenses that provided a personal benefit, like meals or entertainment. Are any deductions questionable? Prepare to demonstrate why they were business-related. The auditor may be willing to forgive some things that are in that gray area, Chester says.
5. Organize documentation.
There’s nothing like an audit to get your books in order. Files and documentation should be easy to access and review by an outsider. Every check should have an invoice attached to it, says Chester. Copy and arrange documentation that supports business expenses so that the process goes as smoothly as possible.
6. Move forward.
“It’s good practice to always ask who the examiner’s supervisor is,” says Eisenkraft. If the auditor goes on leave or both sides arrive at an impasse, “it’s time for a manager or supervisor to get involved,” she says. “You don’t want to let months go by without any kind of dialogue between you or your representative and the auditor.”