But you know what? The experience doesn’t have to be that bad as long as you take a few precautions and stay smart about how you handle the process.
Consider these tips and techniques to minimize the damage and dial down the distress.
Tip #1: Make Sure Your Books Are Clean
A first tip—and probably the single most important thing you can do: Make sure your accounting system works right and that you’ve got good documentation to support the transactions the accounting system shows.
If you have a good accounting system (pretty much any accounting software program will work just fine)… and you use it correctly… and you keep good supporting documentation to explain the stuff in your accounting reports, you will be fine. Seriously. You will have little to worry about.
Note: In his excellent book Surviving an IRS Tax Audit (Nolo Press, 2012), tax attorney and tax professor Frederick Daily notes that IRS wins the majority of its audits mostly because people can’t back up their tax return with good recordkeeping. Accordingly, you want to operate a good accounting system and keep good records.
Tip #2: Hire a Ringer to Represent You
Except in the case where the audit is a “correspondence exam” you can comfortably handle yourself via the U.S. Mail, you probably should not take a do-it-yourself approach to an IRS audit.
Here’s why: Commonly the auditor will only look for things that increase your taxes and will miss things that decrease your taxes during the audit.
Now this seems totally bogus, I agree. And it appears to violate two rights described in the IRS’s Taxpayer Bill of Rights (available here).
The third “right” listed, for example, is this:
- The Right to Pay No More than the Correct Amount of Tax. Taxpayers have the right to pay only the amount of tax legally due, including interest and penalties, and to have the IRS apply all tax payments properly.
The tenth “right” listed is this:
- The Right to a Fair and Just Tax System. Taxpayers have the right to expect the tax system to consider facts and circumstances that might affect their underlying liabilities, ability to pay, or ability to provide information timely. Taxpayers have the right to receive assistance from the Taxpayer Advocate Service if they are experiencing financial difficulty or if the IRS has not resolved their tax issues properly and timely through its normal channels.
But I feel like more and more commonly, the auditors are lopsided in their exams.
For example, an auditor may immediately spot a $20,000 deduction you took but were not entitled to but then miss another $20,000 deduction you were entitled to but did not take. This doesn’t happen with every auditor. Some are very fair. But some are not. And the fact is, even a little lopsidedness in finding and disclosing errors will beat you up in an audit.
Accordingly, just go ahead and let the audit focus on stuff that will jack your taxes but then hire a tax attorney, CPA, or enrolled agent (EA) to both look for missed tax deductions and also to quarterback the examination.
Tip #3: Skip the Face-to-face Interview
I have one other tip related to a small business IRS audit: You should, based on my recent professional experiences, skip having a face-to-face interview with the auditor. Instead, have the auditor submit questions through your attorney, CPA, or EA.
This person can then submit the questions to you and help you accurately and honestly answer them.
I make this suggestion not because the auditor can’t be trusted in an interview. He or she can be trusted.
The problem is, frankly, you can’t be trusted.
In other words, you will very likely say something damaging, or at least unhelpful, to your audit. You may for example offer up some (it seems to you) helpful tidbit that only sends the auditor off on a wild goose chase. Or you will describe something you’ve done in a manner that undermines or conflicts with stuff you’ve already done on your tax return.
For the record, I am not saying you should lie or that you should avoid telling the truth. You never want to lie to the IRS.
But you also don’t want to provide an auditor with random, extraneous bits of raw data that means the auditor spends more time and energy pawing through your records and brainstorming about adjustments he or she can make to your tax bill.
Two Final Quick Comments About IRS Audits
Let me make two other quick comments about IRS audits.
First, in my experience, most small business IRS audits cover really basic stuff. The IRS agent is not going to spend time looking at some complex issue that requires extensive research or a team of experts.
Rather, the agent will do things like compare bank account deposits to your business’s income to make sure you’re reporting all your income. And the agent will look at any big, odd deductions that appear in your tax return to make sure that you’re only deducting stuff that’s an ordinary and necessary business expense.
Maybe another way to say this same thing: The small business IRS agent looks (in my experience) for the big, low-hanging fruit.
A second comment: You want to be, and look, and operate in a professional, high-integrity manner. A lack of integrity will be pretty apparent once the auditor gets into the financial details of your business. And a small business owner who seems professional and trustworthy will likely get some breaks from the IRS agent.
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