Getting a letter from the IRS that your tax return is being audited may strike fear into the hearts of individuals and business owners. But with a little advance preparation and planning, you should fare well.
In the fiscal year 2019, the IRS audited approximately 0.4% of individuals. Generally, self-employed businesses, flow-through businesses (LLC & S Corporations), large corporations, and high-income individuals are more likely to be audited. Overall, all types of audits are being conducted less frequently than they were a decade ago, but that’s little consolation if your return is among those selected to be examined.
There’s no 100% guarantee that you won’t be picked for an audit because some tax returns are chosen randomly. However, the best way to survive an IRS audit is to prepare for one in advance. Being properly prepared and having complete records of necessary documents will reduce anxiety and stress if you were to be chosen for an audit. On an ongoing basis, you should systematically maintain documentation — invoices, bills, canceled checks, receipts, legal papers, travel/lodging records, tax payments, loan agreements, or other proof — for all items to be reported on your tax returns. Keep all your records in one place and keep it organized by year.
Red Flags That Could Trigger an Audit
It helps to know what might catch the attention of the IRS. Statistically, certain types of tax-return entries are known to have a higher error/inaccuracy rate so they may lead to an audit. Here are a few examples:
- Significant inconsistencies or variances between the tax returns filed in the past and your most current tax return.
- Gross profit margin or expenses markedly different from those of other businesses in your industry.
- Miscalculated or unusually high deductions.
- You deduct 100 percent of a car for business use (and personal use is not included in compensation).
- Your deductions report nice round numbers.
Certain types of deductions may be questioned by the IRS because there are strict recordkeeping requirements for them — for example, meals, auto, and travel expense deductions. Maintaining contemporaneous records as follows: mileage logs, receipted business meals; travel ticket purchases, and travel dates noted in an electronic calendar can be very helpful when asked to provide documentation and proof of business purpose. In addition, an owner-employee salary that’s significantly higher or lower than those in similar companies in his or her location can catch the IRS’s eye. For S Corporation owners, an unreasonably low owner salary compared to S corporation distributions could trigger a review of your return.
Responding to a letter
If you’re selected for an audit, the IRS notifies you by letter. Generally, the IRS doesn’t make initial contact by phone. But if there’s no response to the letter, the agency may follow up with a call. In very rare situations the IRS may also show up at your doorstep.
OBSERVATION: Ignore unsolicited email messages about an audit. The IRS doesn’t contact people in this manner. These are scams.
Many audits simply request that you mail in documentation to support the business deductions you’ve taken. By having the proper documentation readily available this type of audit can be handled and resolved quickly. Others may ask you to take receipts and other documents to a local IRS office. Again, if you have kept proper records and have them organized, this audit can be very straightforward. Only the harshest version, the field audit, requires meeting with one or more IRS auditors.
Keep in mind that the tax agency won’t demand an immediate response to a mailed notice. You’ll be informed of the discrepancies in question and given time to prepare (generally 45-90 days). You’ll need to collect and organize all relevant income and expense records. If any records are missing, you’ll have to reconstruct the information as accurately as possible based on other documentation.
If the IRS chooses you for an audit, our firm can help you:
- Understand what the IRS is disputing (it’s not always clear),
- Gather the specific documents and information needed, and
- Respond to the auditor’s inquiries in the most expedient and effective manner.
The IRS normally has three years within which to conduct an audit, and often an audit doesn’t begin until a year or more after you file a return. The state department of revenue generally has 4 years to review/audit your return. We advise you maintain proper tax records for at least 6 years in the event your number is pulled. Don’t panic if you’re contacted by the IRS. Most notices that the IRS sends out are computer generated and many are just incorrect. With respect to an audit notice, most are routine (and focus on 3-4 items reported on the tax return). By taking a meticulous, proactive approach to how you track, document, and file your company’s tax-related information, you’ll make an audit much less painful and even decrease the chances that one will happen in the first place.
Finally, we encourage you to hire a tax professional to represent you in dealing with and communicating with the IRS. A tax professional can keep the IRS focused on the audit and the few disputed items. The IRS will ask you many questions about your return. You may accidentally answer the questions improperly or you may volunteer business/personal information that could expand the IRS’ audit scope.
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