If you are notified by the IRS that you have been selected for an IRS Audit of your business tax return, the most important thing to remember is: Stay Calm. If you are notified by phone, remember to be polite and refer the auditor who called to your tax professional who prepared your business tax return. Whether you’re notified by phone or correspondence, your first call to action is going to be: Compiling documentation. You will need to furnish receipts, invoices, and other documents; so make sure your compilation is complete.
Why Has my Business Been Targeted for an IRS Audit?
Only 2-4% of tax returns or less is actually audited by the IRS, and there are a variety of reasons why your business has been selected for an IRS audit. Your business may be within a specific sector or socio-economic status for which “test compliance” is being conducted. Perhaps you have a disgruntled employee or a fierce competitor trying to get you caught up. Your business could have come up during the audit of another business or individual, and it’s even possible that your business was just randomly selected by a computer.
No matter what the reason, the IRS agent in charge of conducting the audit should be able to tell you why your business was targeted. It’s up to you to ask the question, though; the auditor is under no obligation to tell you the reason for your audit if you don’t ask.
Another reason your business could have been selected is if your return reported an abnormal numerical score. The numerical score is used by the IRS to determine an average return and identify businesses that are significantly outside of that average. A numerical score is determined by taking a number of tax return items into consideration and placing them into an algorithm. The actual formula for arriving at the numerical score is secret, but here are some of the items which are factored into the score:
- Excessive automobile expenses
- Excessive use of business vehicles
- Excessive travel expenses
- Excessive entertainment expenses
- Excessive interest expenses
- Low profit margins
Important Note about Interest Expenses: When claiming interest expenses on your business tax return, you are not allowed to include personal interest of yourself or any other board member. This very item is of special consideration by the IRS, and can lead to a suspiciously high score for which an audit will most likely be triggered.
Types of Audits
There are 4 different types of audits which may be conducted by the IRS. We will list them here and discuss each one in greater detail. The 4 types of IRS audits are:
- Correspondence audits
- Office audits
- Field audits
- TCMP audits
A correspondence audit is generally reserved for very small returns. As such, it is unlikely your business will be audited by correspondence. As you can infer by its name, a correspondence audit is an audit which is conducted by mail. The IRS will send you a letter and ask you to return receipts, invoices, or other financial documents to satisfy the audit.
This type of audit is common for small businesses and/or sole proprietors with a gross sales volume of $500K or less. If your business is targeted for an office audit, you will receive notification by mail. In the letter you receive, you will be asked to compile specific documents and bring them to your closest IRS office to be reviewed by a local agent. If your professional tax advisor is able to attend the audit, you do not have to be there.
A field audit is generally conducted on tax returns from corporations and partnerships. If your business is selected for a field audit, the investigating agent will meet you at an office of your choice rather than having you travel to the IRS office. In the event of a field audit, the agent to conduct your audit will call you personally. During this conversation, the agent will generally ask:
- Information about corporate officers
- Name of professional tax preparer
- Where records are stored
- Which records you will need for the audit
If a field audit is being conducted, it’s very important for you to have professional representation. Aside from the amount of experience in dealing with an audit a seasoned tax professional will have, it’s important to have representation so the audit can be conducted in his/her office rather than your place of business. By making sure the audit is conducted in a place other than your office, you are avoiding the IRS agent from dissecting the location in which your business is conducted.
Why is it important to prevent the IRS agent from seeing your place of work? When an agent visits you at the place in which business is conducted, he/she will be looking at every office and workstation, asking questions and probing you about every aspect of operation – giving them more and more topics to discuss during the course of your audit.
The IRS agent who will be conducting your audit will have complete freedom and may examine various sections of your tax return. The items to be examined or questioned are up to each auditor, so there is no way of knowing exactly which questions he/she will ask. Generally speaking, an auditor will research items which seem to be way out of the average scope on an ‘ideal’ tax return. You may have an agent who nitpicks every minute item on your return. If this is the case, remember to stay calm and avoid being short or belligerent.
Depending on how your audit goes, the agent may be inspired to ask about previous years’ tax returns. You may not be able to avoid this measure, but there are things you can do to ensure another year’s tax return just doesn’t come up. Make sure to have all of your documentation for only the tax year in question. If you have spreadsheets for multiple years, create one for the current tax year only. Your representative will be answering questions directly and not divulging any extra information. When you’re questioned directly about business operations, be sure to do the same and avoid mentioning any credits or carryovers from previous years.
The TCMP (Taxpayer Compliance Measurement Program) audit is conducted for the purpose of creating the numerical score algorithm. The information obtained through these audits help to identify average levels of each item on business tax returns. Because the audits are being used to compile statistical data, every line of the return must be examined as opposed to various discretionary sections which are common in regular audits.
How to Deal with an IRS Audit
If your business is selected for an audit, don’t panic; stay calm, and get organized. Compile all necessary documentation so that you’re ready when the IRS agent confronts you with questions. The more organized you are with your documentation, the cleaner you appear to the IRS agent. An appearance of being open and honest will go a long way with the IRS agent, and it may even cause them to question fewer items than they otherwise would have. Also, the more organized you are the more quickly you will be able to furnish documents. This generally encourages the agent to spend less time examining them.
You have the option of attending the audits on your business and/or having a representative handle the audit for you. If you choose to face the audit alone without representation, remember that there is no such thing as a conversational question with an IRS agent. Every question is posed with 1 of 2 motives in mind: To locate unreported income or to identify overstated deductions. Here are more tips for you if you decide to host your own audit:
- Provide only requested documents; do not offer to supply extra
- Never offer more information than what is being asked for by the agent
- Offer honest and concise statements
- Provide copies for the IRS; make sure to hold on to your original document
- Refrain from in depth conversations with the IRS agent
- Remain calm during the audit
- If you have representation, make sure your representative reviews all forms before signing
- Make sure to obtain copies of all forms you sign
Prior to Your Audit…
Before your audit takes place, your contracted professional will help you compile required documentation. Additionally, he/she will be able to advise you on what types of questions may be asked and how to adequately prepare for questioning.
During Your Audit…
A professional tax adviser can conduct the entire audit in your place or in your presence. A contracted tax professional will be less emotional and defensive than you will be and is well-versed in the legal jargon required to discuss the actual law.
At the End of Your Audit…
You will have the opportunity to have your representative review all forms with which you are presented before signing. In the event you don’t understand something, your representative will be able to put it in terms you understand.
Your Options Once an Audit Has Been Conducted
Once an audit has been completed you have the option of either agreeing with the auditing agent and signing all final paperwork or appealing the decision with the IRS. It is the responsibility of the IRS agent to inform you on the appeals process and the steps you can take if you don’t agree with the results of the audit. Your paid tax professional will be able to assist you with the appeals process, also.
How well your audit goes will depend on you and/or your representative’s ability to refrain from getting emotional and answer questions directly. If you need help preparing for an audit of your business tax return, please get in touch with us.
I.J. Zemelman, EA is the founder of Taxes for Expats