DON’T PANIC! This is my first bit of advice to anyone who has a business selected for a tax audit. Whether you are a small business CEO or a general counsel for a larger business, receiving a notice from the IRS tends to inspire panic in even the most stoic among us. However, it doesn’t have to. I want to offer a few ideas for steps to take to ratchet the panic level down.
Second, I recommend that you NOT pick up the phone to call the IRS. Usually, this creates more problems than solutions. However, DO pick up the phone to call an experienced tax attorney or Certified Public Accountant (CPA). These are the folks who can talk you off the ledge when the IRS has you a bit flustered. Attorneys and/or CPAs have the knowledge to assist with whatever tax situations may arise. You are not likely to surprise them with anything that comes up in your audit. Even if you do surprise them, they can help you figure out viable solutions to the problem.
The next step is to gather necessary documentation. This makes your Attorney or CPA’s job much easier. Keep in mind that every audit focuses on certain aspects of a return. The kinds of records requested will most likely be on the following list. No records stand on their own. The circumstances surrounding the document sent must be included. Based on information from the IRS website, our firm usually recommends gathering the following information: https://www.irs.gov/businesses/small-businesses-self-employed/audits-records-request):
- Receipts – Provide in date order and include notes on what they were for and how they relate to your business.
- Bills – Include the name of the person or organization receiving payment, the type of service paid for and the dates you paid them.
- Canceled checks – pair these with copies of the bills they paid and any applicable employer reimbursement.
- Legal papers – Include a description of what the case was about, when it happened and how it relates to your business, credit or deduction. Examples include:
- Divorce settlements including custody agreements
- Criminal or civil defense papers
- Property acquisition
- Tax preparation or advice
- Loan agreements – Include a copy of the original loan with the following:
- Names of the borrowers
- Location of the property
- Financial institution making the loan
- Amount borrowed
- Terms (the number of months to pay)
- Settlement sheet
- If the loan was from an institution, include an end of tax year statement indicating interest paid
- If the loan was not from an institution, provide a statement from the payee indicating the interest paid that year as well as the payee’s address and Social Security number
- Provide a breakdown of how you used the money
- Logs or diaries – These might show the dates and locations of your travel as well as the business purpose and mileage. These might also show gambling winnings and losses as well as dates and locations. These might also show job-hunting activity and expenses.
- Tickets – Label travel tickets with the business purpose for the trip and group them with other receipts from the same trip. Lottery tickets help provide proof of profit or loss.
- Theft or loss documents
- Insurance reports detailing the nature of the loss or damage
- If not insured, copies of fire department or police reports on the loss, theft or accident
- Photos or video showing the extent of the damage (if available)
- Appraisal from a qualified adjustor showing fair market value of the property before and after as well as an estimate of the damage
- Brief explanation of the loss
- Employment documents – These might include uniform policies or dress codes, continued education requirements, and W-2 reimbursement statements or policies.
- Schedule K-1 – These are used to report each shareholder’s share of income, losses, deductions and credits when an S corporation files its annual tax return.
- General ledger – For the time frame being audited. For extra preparation, include the year before and year after the designated audit year, since the IRS may look at these years to verify if anything affected the year under audit.
- Bank statements – Same as the general ledger: include the audit year, but for extra preparation pull the year before and after in case the IRS requests these as well.
Finally, we recommend that your expectations stay reasonable. Audits do not always mean that you will have an unfavorable outcome. If your documentation is solid, often you may walk away from an audit with limited corrections from the IRS. However, if documentation was not solid, or other issues are in play, your business may have some liability that must be addressed. Keep in mind that this is not the fault of your tax attorney or CPA and is usually due to incomplete or incorrect bookkeeping and record keeping. A good tax attorney or CPA can typically negotiate with the IRS to assist in lowering your liability, but you may have monetary ramifications that are involved in resolving the issues arising during the audit. While a professional may be able to negotiate lower liabilities, erasing the liability is not likely.
Ideally, you will not ever have to suffer through a tax audit of your business. If you do, however, you will save yourself time and panic by having good records. Make sure you keep track of past tax returns, invest in a good scanner to scan receipts and other documentation, and ensure the retention of supporting documents. You will need to plan to keep no less than 3 years of tax information, but ideally maintain the last 7 years of tax information. The IRS usually only goes back 3 years in an audit, but if issues are uncovered, they reserve the right to go back a bit further. Specifically, the IRS website recommends the following (https://www.irs.gov/businesses/small-businesses-self-employed/how-long-should-i-keep-records):
- Keep records for 3 years if situations (4), (5), and (6) below do not apply to you.
- Keep records for 3 years from the date you filed your original return or 2 years from the date you paid the tax, whichever is later, if you file a claim for credit or refund after you file your return.
- Keep records for 7 years if you file a claim for a loss from worthless securities or bad debt deduction.
- Keep records for 6 years if you do not report income that you should report, and it is more than 25% of the gross income shown on your return.
- Keep records indefinitely if you do not file a return.
- Keep records indefinitely if you file a fraudulent return.
- Keep employment tax records for at least 4 years after the date that the tax becomes due or is paid, whichever is later.
If you can follow the above advice, you will ensure you have a much less stressful audit. Hopefully you are able to preempt audit issues by providing full documentation. This will limit your liability and lower the costs associated with the audit. Remember, just breathe, call an experienced tax attorney or CPA, and let us handle the hard part. Tax audits don’t have to be scary!