So, you’ve received that dreaded letter from the Internal Revenue Service (IRS): You’re being audited. Fear and apprehension take hold. Should you be worried?

No, not necessarily.

If you’ve kept good records and have been honest, then you shouldn’t be concerned about an IRS audit. You should prepare to pass it. Here’s what to expect.

How Does the IRS Notify You of an Audit?

The IRS always notifies the subject of an audit by mail. The IRS doesn’t send emails or make telephone calls about an upcoming audit. Any kind of communication other than regular mail is a scam and you should immediately contact the IRS.

What’s in an IRS Audit Letter?

The audit letter will:

  • Specify the documentation or information that the auditor wants to examine.
  • Have instructions for the steps to follow.
  • Set a date by which you must contact the IRS to set an appointment.
  • Contain the auditor’s contact information.

You should follow the instructions carefully and provide the information requested. Even if you don’t have all the documents they want, get in touch with the IRS before the deadline. Delaying your response may arouse suspicions that you have something to hide and will only make the situation worse.

An IRS audit can be either done by mail or in person.

An IRS Audit: What is It?

The purpose of an IRS audit is to determine if an individual or business has reported all taxable income, expenses and deductions in compliance with federal tax regulations. If the auditor finds an error, the business may be forced to pay additional taxes in addition to penalties and interest.

An audit can be either done by mail or in person. Paper audits are usually the result of a minor error and can be easily fixed by providing additional documentation or making a payment if the additional tax due is small.

If the IRS feels the problems cannot be solved with correspondence and further investigation is required, it will conduct a field audit. In this case, you would meet with an IRS agent, either at an IRS office or at your place of business.

Either way, you have the right to engage a professional tax preparer to advise and represent you before the IRS.

How Far Back Can the IRS Audit Your Business?

The IRS has the authority to audit returns filed within the past 3 years. However, if the IRS auditors believe they have uncovered substantial errors, they can go back further, but usually not more than 6 years. Because the IRS likes to audit the most recent returns, the majority of audits will be for returns filed within the past 2 years.

If the IRS can’t resolve a dispute, they may request an extension of the statute of limitations, which lengthens the time permitted to assess additional taxes. At the same time, an extension will give you more time to furnish additional documentation, request an appeal if you don’t agree with the results of the audit or claim a credit or refund.

Be aware that you aren’t obligated to agree with the IRS for an extension of the statute of limitations. However, if you refuse, the auditor will have to make a decision based on the information as presented. This could be either good or bad for you, depending on the circumstances.

How Long Does an IRS Audit Take?

According to the IRS: “The length varies depending on the type of audit; the complexity of the issues; the availability of information requested; the availability of both parties for scheduling meetings; and your agreement or disagreement with the findings.”

 

The IRS auditor will review your company’s financial statements.

If You Get Audited by the IRS, What Happens?

The IRS auditor will compare your business’s financial statements with the tax return for the year being investigated. The auditor could ask for additional source documents, such as bank statements, receipts and invoices.

You only need to provide the documents that support the issue under discussion. You should never give the auditor any other information if not requested.

Keep in mind:

  • As part of the IRS audit process, the auditor will ask questions that you should answer directly and succinctly. If you aren’t sure of the answer, offer to do the research and provide the answer later.
  • Although the atmosphere during an audit can be tense, you should always remain courteous and respectful to the auditor. While you might become frustrated, avoid being uncooperative and argumentative. It will only make matters worse.
  • The length of an audit varies depending on the type of audit, complexity and availability of information. Disagreements can extend the time of an audit if the findings cannot be resolved.

What Triggers and IRS Audit?

The IRS uses algorithms and random selections to determine which tax returns to audit. These algorithms look for returns that have income and deductions that differ from the norms for the industry. Items outside the norms will get flagged for review by an IRS employee to see if an audit is needed.

Here are 9 examples of things that can trigger an audit:

  1. Meal and entertainment expenses: IRS rules for validating meals and entertainment expenses are specific. You must record the names of people in attendance, location and purpose of the meeting. Anything less will be considered insufficient and will be disallowed.
  2. Using round numbers: While you don’t have to report everything to the penny, submitting numbers that are in multiples of $100 is a flag. For example, making a purchase at Staples for office supplies isn’t likely to add up to exactly $300. If you use a round number, the IRS knows you’re probably guessing and will want further information.
  3. Deductions for home office: Deductions for a home office will draw the attention of the IRS. Deductions for a home office are frequently exaggerated and hard to substantiate.
  4. Using your vehicle for business: If you’re going to use a vehicle for business and personal use, be sure to keep accurate logs with dates and mileage. It takes time and effort, but the data will be needed to validate the deduction as a business expense on your return.
  5. Reporting losses for several years: The IRS knows that startup businesses may report losses in the early years, but a continuous string of losses becomes suspicious. If you are pretending that your hobby is actually a money-losing business while you still have a day-job, the IRS will soon figure this out and open an audit.
  6. Mismatch of 1099s: If you’re operating as an independent contractor and receive 1099 forms, make sure to report all of these as income. The IRS has the computer capability to match 1099s that are issued with the ones that are reported. Underreporting income is a serious problem in the view of the IRS.
  7. Deviations from industry standards: The IRS algorithm looks for deviations from income and expense deductions that are typical for the industry. Higher-than-normal deductions will draw a flag.
  8. Self-prepared returns: The tax code is complex. Small business owners trying to prepare company tax returns on their own may find it a daunting task. The IRS targets self-prepared returns because of a tendency to underreport income. The wiser move is to hire a professional tax preparer.
  9. Charitable deductions: Large charitable deductions get immediate attention and must be supported with documents, such as a professional appraisal for artwork.

IRS rules for validating meals and entertainment expenses are specific.

How to Prepare for IRS Audit

The key to surviving an audit is preparation. You have nothing to fear if you have all the necessary records and haven’t done anything illegal.

The following is a checklist of things to do before an audit:

  • Gather all records that support the information on your tax return. The IRS has the right to examine all documents used to prepare your return.
  • Get organized and put together the specific documents the IRS requested in its audit letter. Don’t just hand over a stack of papers and let the auditor go through them. You don’t want the IRS going through your financial information any more than necessary.
  • Organize everything by category and date to make it easier and quicker to find any documents the auditor may request. Neatness counts. Auditors appreciate a sense of order and may give you the benefit of the doubt in gray areas.
  • If you can’t find or don’t have the necessary information, request duplicate copies from your bank, lender or even the government itself.
  • Make arrangements with your tax preparer to attend the audit if it’s an in-person visit. Many small business owners may not be up-to-date on tax laws. That’s why you hire a professional to do the company’s tax returns.

What are the Possible Results of an Audit?

An audit can have three possible outcomes:

  • No change: The auditor confirms that all information is correct. If everything is accurate, no changes will be made to your tax return and no additional taxes will be owed.
  • Agreement: The auditor finds a mistake, and you agree with the changes. You will sign the examination report with the results.
  • Disagreement: The auditor finds and mistake, and you disagree with the findings. Your options, at this point, are to request a conference with an IRS manager, participate in mediation or file an appeal.

The good news is that an audit doesn’t necessarily mean you’re going to wind up paying more taxes or face legal issues.

With adequate preparation, an audit doesn’t have to be stressful or complicated. If you have the proper support documents and can satisfy the IRS that your returns are in compliance, the outcome will be painless.