How to Handle a Tax Audit

There's nothing that strikes fear into the heart of a small business owner like getting an audit notice. The chance of being audited in any given year is small: About 1 percent of 2008 taxable returns were audited, according to the latest available IRS statistics. But self-employed individuals and small business owners are more likely to be audited than employed persons, particularly if they report adjusted gross income of more than $100,000.Scott Berger, a CPA and tax principal with Kaufman Rossin in Boca Raton, Fla., spoke recently to Smart Answers columnist Karen E. Klein about "hot spots" for IRS audits, what to do during an audit, and how to avoid audits in the first place. Edited excerpts of their conversation follow.

Karen E. Klein: Total audit rates appear to hover around 1 percent, but a report released last year by Transactional Records Access Clearinghouse at Syracuse University shows that small businesses have been increasingly scrutinized over the past five years. What are you seeing?

Scott Berger: The IRS says audit rates are going down, but I'm looking at an inventory that's growing faster by the day. Our clients are higher income, bigger clients, and they seem to get more focus.

What triggers an audit?

The IRS will tell you it's random. Their computers are programmed to look closely at differential scores, but how those are defined is closely guarded. There are all sorts of stories as to what generates an audit, but I don't think there's something specific.

Do certain things make an audit more likely, such as having an office in the home?

It seems like the home office is not as big a deal as it used to be. On the other hand, if the auditor wants to look at the home office and finds the kids' toys in there, they might challenge it.

What seem to be the hot spots are sole proprietorships showing losses and S-corps, where officers' compensation and shareholders' salaries are being examined to see if they are "reasonable."

So, for sole proprietorships that declare losses year after year, eventually they will be declared hobbies, not businesses. With the compensation, the IRS is looking to see that shareholders who get minimal or zero pay are not avoiding paying Social Security and Medicare taxes.

What about the small companies whose revenues have dropped in recent years and the owner decides to forego a salary, even temporarily?

If your company is losing money and your books and records easily reflect that, you may not have to pay yourself a salary. If you show a profit but no compensation, the computer picks that up easily.

What tips would you offer small business owners to help avoid an audit or make it easier to handle?

If you're not incorporated, and you're not segregating your personal financial records from your business activity, that's going to be a big problem when they come and audit. If you keep separate books and records for your business, the audit will be shorter, faster, and it will go a lot smoother.

The IRS particularly looks at expenses, such as meals, entertainment, and travel, where the line between personal and business can become blurred. If there's an audit, documentation will be required to justify those expenses, and many times people fail to keep adequate documentation.

What is "adequate documentation?"

For instance, if you're expensing a meal, you should have an appointment calendar that shows whom you met with and why, and a receipt that shows how much you spent and where.

How are people usually notified that they're being audited?

They either receive a "dear taxpayer" letter in the mail for a correspondence audit that takes place by mail, or they get a phone call from a field examiner, who will follow up with a document request and later schedule a meeting.

What happens during an audit?

Generally, on the first notice, they'll tell you what areas of the return they want to look at. The Schedule C income is the first thing they check, and they want to see all your bank statements and deposit slips. You have to hope that your total deposits equal the income you reported on your return.

If you have an in-person appointment, it generally lasts two to four hours, with you sitting there spoon-feeding them pieces of paper. It's something like a colonoscopy without anesthesia.

I've heard you should book your appointment just before lunch.

Yeah, Friday late afternoon appointments are great, too. Doing those kinds of things may not help, but they certainly can't hurt.

Do you have advice on how to behave during an audit?

Be respectful and try to develop a rapport. Being organized helps; if you're disorganized, it may make them want to expand the scope of the audit.

What's the outcome of an audit?

The auditor issues you a report, and you either agree or don't agree. You can ask for supervisory review, or you can request an appeals conference, which is with an independent party outside the examination group, or you can go to tax court.

Generally speaking, you either get a balance-due report, which shows tax, penalties, and interest—or a "no change" letter, which is what we call "Willy Wonka's famous golden ticket."

How often does that get issued?

If you have good books and records and can tell a good story about your business, you have a better chance of getting one. If you're scrambling, and you have errors on your return, you have a better chance of getting a balance due. I've seen balances as high as tens of thousands of dollars.

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