Audit Preparation

If there is one thing that strikes fear in the heart of a businessperson, it’s a notice from the Internal Revenue Service saying it is about to conduct an audit of the business. By Gary R. Crum When the Tax Man Cometh‘Always Prepared’ is good advice for tax auditsBy Gary R. Crum

If there is one thing that strikes fear in the heart of a businessperson, it’s a notice from the Internal Revenue Service saying it is about to conduct an audit of the business.

The IRS is putting more emphasis on audits of what it calls “flow-through” returns. This refers to business income that flows to individual tax returns, such as partnerships and S corporations. In 2007, audits of S corporations increased 26 percent, partnership audits were up almost 25 percent and audits of businesses in general increased 14 percent over 2006.

Small businesses are especially vulnerable since, according to the IRS, they tend to write personal expenses such as entertainment or equipment for home use, through the business. Therefore, the IRS has increased the audits of these types of returns.

The IRS has tools to help it identify taxpayers who are under-reporting income or claiming excessive credits and deductions. These include special computer programs that give each return a numeric “score” that allows comparison to national norms.

Ken Saxon, CPA, the owner of Saxon CPA LLC in Tallahassee, points out that some groups are more likely to get caught up in IRS audits than others. These include self-employed businesspersons who have extensive or expense write-offs.

Saxon cautions that avoiding an audit is not a science because the IRS can randomly pick a return.

“They may just pick a return for training purposes,” he says. The IRS admits that some audits are done to establish benchmarks for auditing other returns.

Ralph Havens, director of JK Harris & Company’s Professional Services division, who heads up the company’s Tax Audit Representation Department, echoes that notion.

“The IRS might pick restaurants one year and business services the next year,” he says. “Other than avoiding obvious abuses, there is no way to systemically avoid an audit.”

But statistics are an important part in the selection process.

“The IRS uses a series of mathematical checks to look for anomalies and scores,” Saxon says. “The IRS checking system may say an expense looks high. For example, a plumbing business with meal expenses of $3,000 would be a red flag.”

Watch for Round Numbers

The numbers themselves can be a sign that the tax filer just plugged a number into the tax return.

“For example, if you use a round number, like $5,000 for an expense, you’re asking for trouble,” Saxon says. “The best thing is to keep good records. Use accounting software such as QuickBooks, where you track and memo each expense. Keep the paper backup.”

Another argument for accounting software is that the integrity of your data is the first thing the IRS is going to check.

“The IRS will want to tie your tax return to your financial statements and it’s easier for them to do that if you use automated accounting software,” Saxon says. “They will check that the numbers are reconciled periodically to confirm the information is accurate.”

Armed with your tax return and a series of questions to be answered, the IRS will show up and start the audit by taking samples of a set of transactions. For example, if there are questions about employee benefit expense, the auditors will start by looking at 100 transactions related to those expenses.

The Details Make the Difference

“The IRS is going to ask for supporting detail,” Saxon says. “If you can produce good detail, it will be OK. If not, they will increase the scope of the examination to 500 transactions. Based on their findings, they may disallow all transactions.”

Personal tax returns are also in play during a small-business audit. The IRS will use personal tax returns to verify information in the business tax return. Expenses will get special scrutiny, according to Saxon.

“Small businesses always have something that falls through the cracks,” he warns. “They are known for sloppy documentation of business expense.”

Havens, of JK Harris & Company, warns that new businesses often don’t know about other tax issues, such as self employment taxes.

“Self-employed people often fail to file quarterly tax reports and deposit estimated taxes with the IRS,” he says. “That is one good reason for a new business to have competent tax advice.”

Accounting for Business Expenses

What are the rules of thumb for business expense?

Saxon offered these two questions to ask about each expense item: Is the expense ordinary for your type of business? Is the expense necessary, reasonable and is there a business purpose?

“We recommend small businesses use separate checking accounts and not commingle business funds with personal funds,” Havens says. “That way, the bank account can be used for backup in the event of an audit. We also recommend that small businesses use a separate credit card for expenses. If documents are lost, the IRS can look to the credit card records for backup.”

Keeping good records and documentation is the first step, but if you receive a notice of audit from the IRS, the first person to call is the accountant or CPA who prepared the tax return.

“I would doubt that many business owners look at the tax returns prepared by their outside accountants,” Saxon says. “Whoever did the tax return should handle the IRS.”

Knowledge of the tax return isn’t the sole issue. The business owner’s emotions sometimes will get in the way of a successful audit, according to Saxon.

“The CPA has been through audits before and knows the best way to deal professionally with the IRS auditors,” he says.

When the auditor arrives, you don’t want him hanging around to find additional audit questions.

“My goal is to get the auditor out as fast as possible so he keeps centered on the current-year audit to minimize the impact on the client,” Saxon says.

IRS audit findings sometimes can be expensive to resolve, and the experienced CPA may be able to negotiate a better outcome.

“I was involved in one situation where employees were given tax-free cash Christmas gifts by the business owner,” Saxon says. “The IRS wanted to tax the recipients on the money paid since it was income, but we were able to negotiate a payment by the owner, instead of passing the tax liability to the employees. That was the most economical solution.”

“The IRS is usually black and white,” Havens says. “If you have made an error in your tax return, you want a tax professional to help negotiate a settlement.”

They say life isn’t fair, and the IRS audit is no exception. According to Saxon, when an auditor decides something, that is the final word.

“If you disagree with the exam findings, you can’t argue with the examiner; you have to go through an appeals process,” he says. “If you lose on appeal, the next step is tax court. It can be expensive.”

How you use your tax accountant also is important. The more he or she knows about your business, the better.

“If you are using a CPA just to prepare a tax return, the CPA does not have a chance to do anything but take a cursory look at your information,” Saxon says. “It is always better when the CPA understands the client’s business.”

This article is for general information only and should not be considered as accounting advice or counsel. Such advice can only be properly given by qualified professionals who are fully aware of a user’s particular circumstances.