Hints On Surviving A Tax Audit

Nothing scares a small-business owner more than receiving a letter from the IRS demanding an audit. It’s no surprise that small companies are more susceptible to an audit than larger companies. Therefore, it’s important to know how to survive one.

Over the past five years, the IRS has increased the hours it spends auditing small businesses with less than $10 million in assets by 30%, while reducing the time it spends auditing large companies, according to a new report from Syracuse University’s Transactional Records Access Clearinghouse.

Scott Berger, a tax principal with the accounting firm Kaufman, offers some advice for small businesses.

“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,” Berger says. “The IRS particularly looks at expenses, such as meals, entertainment, and travel, where the line between personal and business can become blurred.“

According to Berger, the IRS selects returns with the highest potential return on the time and energy the agency expends to audit.  One factor is a computer-generated score called the Discriminant Indicator System score, using data from similar returns to predict the potential revenue that might be gained by auditing the small business.

He says that the IRS will tell companies that its choice of whom to audit is random. The agency’s 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, Berger says, but he doesn’t think there’s something specific. 

“It seems like the home office is not as big a deal as it used to be,” he says. “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.”

Berger believes that the current hot spots seem to be sole proprietorships showing losses and S-corporations, where officers’ compensation and shareholders’ salaries are being examined to see if they are “reasonable.” So sole proprietorships that declare losses year after year, eventually 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.

When asked why the IRS has begun to focus more tightly on small businesses, Berger gives this example: The IRS recently uncovered more than 40,000 taxpayers who did not properly disclose beneficial or ownership interest in foreign financial accounts by filing Form TD F 90-22.1.  The penalty for not filing the form is up to $10,000 per violation.   People must also disclose transactions with foreign trusts and receipt of certain gifts on Form 3520.  The penalties for not filing Form 3520 are typically a percentage of the assets transferred.

Berger offers these specifics for getting through an audit successfully:

  •  If the owner keeps separate books and records for the business, the audit will be shorter and faster, and it will go a lot smoother.  If there’s an audit, documentation will be required to justify expenses, and often people fail to keep adequate documentation. For instance, if the owner is expensing a meal, he or she should have an appointment calendar that shows whom he or she met with and why, and a receipt that shows how much he or she spent and where.   
  • Generally, on the first notice, the IRS will tell the owner what areas of the return the agency wants to look at. The Schedule C income is the first thing that will be checked, and the IRS will want to see all bank statements and deposit slips. Owners have to hope that their total deposits equal the income they reported on their return. 
  • If the audit is scheduled as an in-person appointment, it generally lasts two to four hours, with the owner sitting there spoon-feeding the IRS pieces of paper. The owner should be respectful and try to develop a rapport.  
  • Being organized helps; if the owner is disorganized, the auditor may want to expand the scope of the audit.