A sole proprietor who files a Schedule C with his or her Form 1040 that reports $100,000 or more in gross receipts, has a much higher audit profile than the typical employee who receives that amount or more reported on a W-2. An IRS audit can be a scary proposition for a small business owner. However, there are things a sole proprietor can do to assess the risk, and prepare for and respond to an audit that can make the process less painful.
If you did all of the right things when you filed your return, you should have your records in decent order and you should have retained them for seven years (the statute of limitations is ordinarily three years but could be extended). If you did not set aside your back up documentation, this is the time to find the receipts, and confirm that all income was reported.
Look at your tax returns for the years under audit, and verify that you have documentation to support the deductions claimed. If itemized receipts are not available, use your accounting software, bank statements, credit card statements, and calendar, to back up your income and expenses. If you don’t have records, do not attempt to fabricate them. Contact a tax professional who can help you determine if there is a way to support claimed deductions using available information.
The IRS uses different methods to audit taxpayers. The most common method is a correspondence audit. An IRS examiner will contact you by mail and advise you that your return has been selected for audit. You will be asked to send certain documentation. You may not have any contact other than correspondence.
The second type of audit is a desk audit. Again, you will be notified by mail and will be asked to appear at an IRS office, and to bring with you certain documentation. You will have the opportunity to set a mutually convenient date. This will involve a face-to-face meeting with the auditor who may take the opportunity to ask questions. You can expect the office part of the audit to be completed on the day of the meeting. Both a correspondence audit and a desk audit will focus on particular issues.
The third method is a field audit. An examiner will call to schedule a visit to your place of business. You will be asked to have all of your records available. A field audit is not confined to specific issues. The auditors will ask questions and possibly do formal interviews. These audits can take several days (for large businesses they can take months).
Many things—or nothing at all—can trigger an audit. The IRS does not publish its audit criteria. It does collect data to monitor average deductions and types of income for various industries, including business consultants. Excess deductions or expenditures that are out of balance with reported income may prompt an audit. There are other possible triggers, including doing business with a company already under audit, or a tip off from neighbors or employees who suspect that income is not being reported, or excess deductions are being claimed.
Finally, the IRS selects some returns at random each year to test its audit criteria and to assess compliance, including whether or not the required compliance is too burdensome. The IRS examiner is obligated to tell you why you are under audit and the answer may dictate whether you want to enlist professional assistance.
The IRS examiners are expected to manage a certain case load. The faster they can close your audit, the happier they will be. If you drag your feet, they will be inclined to conclude that you have inadequate records. They also have the option to close out an audit with adjustments after a sufficient period of time has elapsed without a response.
When you are pressed for time for business or personal reasons, and need to postpone the audit, communicate with the IRS examiner. An examiner can and often will put the audit on hold if you have a reasonable basis for requesting the delay. If the time required to respond to the audit is more than you can spare at any time, hire a tax professional to do it for you.
The IRS is a large organization. Things go astray or people who ask the questions may not be involved at the end of the process when adjustments are issued. Document everything. In correspondence audits, send all documents certified mail with return receipt requested. If you are able to send things via fax (the IRS will not accept e-mails), make sure you get a confirmation that the fax went through. In an office or field office, get receipts for any documents you provide. If the examiner wants to interview you, ask to tape the interview. If you agree to an adjustment, immediately send a letter to the examiner confirming that adjustment. Assuming you reach an agreement with the examiner about how certain items will be treated, you will want to retain a record of that agreement to protect yourself if you file future returns based on that agreement. Get copies of anything you sign for the examiner.
As noted, the audit may not be triggered by anything reported on your return or by anything in particular. Treat the audit as a necessary aspect of doing business. It is possible that you may discover that you did not take advantage of certain deductions or credits that were available to you, in which case you can bring them to the attention of the examiner. The examiner is obligated to make both positive and negative adjustments to a return.
Any time you had a paid preparer do your return for a year under audit, contact that person when you receive the audit notice. You may be entitled to some free assistance. As long as you understand the issues under examination and have the necessary documentation, you can handle a correspondence audit, and even an office audit, without paid assistance; if not, get help as early in the process as possible.
Engage a representative to assist with a field audit. It is helpful to have all of the examiner’s questions filtered through a representative because of the broad scope of the audit. You can also have the audit conducted at the office of your tax adviser. That limits the access of the examiner to employees who might otherwise respond to casual questions or make uninformed statements.
You can be represented by an attorney, certified public accountant or an enrolled tax preparer authorized to practice before the IRS. You will need to execute a Form 1028 (Power of Attorney) before the IRS will allow your representative to act for you. Engage an attorney if you believe there might be substantial adjustments or penalties. Your communications with the attorney will be covered by the attorney-client privilege.
Do not provide information that the auditor has not requested. Do not offer information about your business. Respond only to those questions asked and do so as succinctly as possible. Examiners are very skilled at pulling out bits of information. The one exception to this rule is where you feel that you have information to support a credit or deduction or where you believe you missed something on the return or made some other error that caused you to pay more tax than due.
Never send original documents to the IRS. Make copies. An examiner in a desk audit or field audit may ask to see original documents, but always give copies for their files. If an examiner wants to review electronic records, do not let them do so on your computers. Most are very ethical and will look only at the information they requested, but you do not want to take that risk.
Instead, copy the data they wish to see in a format that they can read. They have access to most of the typical small business accounting software, but you may need to put the information in a spreadsheet format or run requested reports for them.
IRS examiners are people, too. The vast majority of them will deal with you in a professional manner. It is their job to ask questions and there are times where they may pursue issues that appear to you to be ridiculous. Respond civilly. If you know you will not be able to manage your temper, advise the auditor that you will engage a tax professional to address the matter.
Most audit adjustments are “agreed adjustments.” When there are contested issues, small business owners and self proprietors have the option before the conclusion of the audit to ask for a fast track settlement process. If the contested issues qualify, the matter is addressed within 60 days. Taxpayers can also use the standard IRS appeals process. At the conclusion of the audit, the examiner will issue a “30-day letter” setting out the adjustments. The taxpayer has 30 days to file an appeal of any unagreed adjustment. Sole proprietors with less than $25,000 at issue can use a streamlined appeals process. Both the 30-day letter and the IRS website provide information about how to file the appeal. Most taxpayers opt to engage a tax professional to handle appeals, but it is not required.
Audits are not fun, but they happen. The best way to prepare for an audit is to have your documentation organized when you file your return, and keep that information for at least seven years. Failing that, understand your risk profile based on the type of audit and the reason for the audit. Should you choose to handle the audit yourself, respond promptly and civilly. Be focused and concise in your responses. Document everything. If you choose to engage an outside representative, do so as early in the process as possible.
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