Audits are often terrifying experiences for small business owners, and some likely go to bed each night praying they’ll never be audited. Fear of the unknown grips them, so lets take a look at what to expect, how to prepare, and who to call if you ever get audited.
What is the Auditor Looking For?
Unreported Income
Whether you’re subject to an income tax audit or sales tax audit, unreported income is usually the first stop for an auditor. Income is often reported to the government by multiple parties, allowing them to double check and cross reference. If one party says they paid you X amount, but you report Y, the auditors may come knocking to figure out why.
Questionable Expenses
Certain expenses have a history of abuse, such as meals and entertainment or vehicle expense. The IRS probably has millions of audit results showing people who claimed these as business expenses when they were in fact personal and not deductible.
Appropriate Employee Categorization
The employee vs. independent contractor issue rages on. Despite countless articles and guidance, people still misclassify employees as subcontractors, failing to collect or pay FICA tax and other benefits. The IRS prioritizes this issue because it takes advantage of unknowing workers and hurts the Social Security and Medicare programs.
Deviation from Industry Norms
The IRS doesn’t have the budget or personnel to audit every person and company each year. What they do have is a database of information that helps them use their limited resources investigating things that look wrong. If you stick out from the pack you may be in for an audit.
How Does an Audit Work?
Receive Notification by Mail
The IRS still operates with physical paper and mail. Beware an unannounced phone call, email, or other communication claiming to be from the IRS. Unless they announce otherwise, the IRS will always contact you by mail to initiate an audit. The notice will list the person or company being audited, the type of audit, when the audit will occur, and what they want to look at, among other things. If subject to a state audit, such as sales tax, you can expect a similar paper notice.
Time to Prepare
You will have time to prepare your evidence, usually many months. Beware an auditor who says they are immediately auditing you. While it may be true, it’s highly unlikely and uncommon, and you should contact a different person at the IRS to confirm the legitimacy of the audit before proceeding. In the event you don’t have enough time be sure to contact your auditor and request an extension of time, which they will usually grant, depending on the circumstances.
Audit Occurs
There are generally two types of audits: Mail vs. In-Person
A mail audit is just as it sounds – you communicate strictly by mail. They send you the notice and request for proof, and you mail back your proof accompanied by an explanation and any other vital information. They will then respond by accepting, or rejecting, your proof. You will then have the opportunity to mail in additional support, and the process continues until both parties are satisfied. Keep in mind interest and penalties will accrue as you continue to try and defend yourself.
Note: mail audits don’t tend to be in the best interest of the taxpayer, as many taxpayers fail to prove their point without in-person communication. The process is drawn out longer than necessary, thereby accruing larger penalties and interest.
In-Person
In-Person audits occur at the taxpayer’s home, place of business, or accountant’s office (field audit) or their local IRS or State office (office audit). It may last one day or many as they interview you, review records, and make their determination.
How to Prepare for an Audit
Verify Legitimacy of the Request
As mentioned above, make sure this is a legitimate audit before sending any information. Scammers are everywhere, and they know people are afraid of audits. A simple scam asking to review your tax return could result in you giving away your date of birth, social security number, bank account number, and more. You will always receive notice via mail, and there will always be a contact number given. If you don’t trust that number you can always visit IRS.gov or your state’s website to find general contact information as well.
Contact your Accountant
Hopefully you’re working with an accountant, because this is where their expertise will really help you. Not only do they have experience dealing with the IRS, they understand accounting and tax terms and laws you don’t, preventing you from being bullied or intimidated. They can also help you keep your foot out of your mouth.
Gather Documentation
Audits have a statute of limitations, for example three years for an income tax audit. You should gather all of the information you need and none that you don’t. Completeness is key here. Any income or deductions that lack support will be thrown out. Don’t have a receipt? Contact the vendor! Many vendors have large databases that go back a while. They may be able to help you.
Determine your Position
With all of this information and the advice of your accountant in your ear, you should know your position before the audit begins. You may concede you do owe something, or you may know you don’t and have the proof to show it. You never know how good or bad your auditor will be, so don’t count on them doing it right. When their determination comes back you can continue to fight for what you know is right. In those cases it can help to have an accountant present the information differently and in a way the auditor can understand.
Tips for Avoiding an Audit
Even though you understand audits now, I’m sure you still want to avoid them. So, what can you do?
File in a Timely Fashion
As mentioned above, audits have a statute of limitations, but only if you file. Failing to file leaves your statute of limitations open forever. File on time to start the clock and not stick out from the pack.
Report Everything Accurately
Seems simple, but it continues to be an issue. Report your income, claim your deductions, and pay your taxes on what’s left. The government has more resources than you, and if you end up in their crosshairs you will pay for breaking the law.
Record Retention
The burden of proof lies with you, the taxpayer. Follow proper record retention guidelines and you won’t be complaining about any lost deductions or extra tax when the time comes.
Work with a Professional Accountant
Not happy about that line above, ‘pay your taxes on what’s left’? Work with a professional accountant and get that number down! Tax law is incredibly complex and constantly changing. The tough times during the pandemic are a perfect example. Many that worked with a professional accountant are still in business because they got a PPP or EIDL loan, and most recently took advantage of the ERC if they qualified. Those that didn’t may be out of business, cursing bad luck without even realizing these programs were created just for them.
Working with Haworth & Company, Ltd.
Hopefully we’ve reiterated enough why you need a professional accountant in your life. If you don’t have one, or are looking to switch, please consider Haworth & Company. We have over 30 years experience helping Minnesotans like yourself run successful small businesses, achieve personal dreams, and make the tax law work for them. Give us a call or contact us today and let’s get started.
