How to Deal with Audits

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Just the idea of having a problem with the IRS is enough to worry many business owners. The tax system can be difficult to deal with even at the best of times. When something goes wrong, it can be a long and expensive process to resolve.

Audits: The Biggest Worry

There are some ways to minimize the risks of being audited, suggests Kevin Packman:

Keep good records that tie in exactly to income and deduction figures on the return. There should be specific information placed on a return. For example, small business owners should try to categorize their expenses rather than just list them as "other expenses" or "miscellaneous expenses."

Packman specializes in advising businesses on tax questions. He is an attorney with Holland & Knight LLP.

But, especially for small business owners, audits can be unavoidable. On top of the IRS' ability to randomly audit businesses, whether or not there seems to be a problem with the paperwork, by their nature, many small businesses catch the IRS' attention. Packman continues:

There is no one issue that will cause an IRS examination. In the case of small businesses organized as an S corporation the IRS pays close attention to whether a small business owner is receiving adequate compensation. If the business owner is not receiving any compensation, this will be noticed by the IRS while choosing returns for examination. An excessive amount of purchases in a year with very little or no ending inventory as part of cost of goods sold is also a likely audit issue. Excessive travel, meals and entertainment depending on the type and size of business may also come to an examiner's attention. In general if the deductions or gross profit percentage of a small business that is not a startup are way in excess of industry norms (easily determinable with BLS statistics), the small business may very well be examined.

Making Audits Less Painful

You can minimize the pain involved in an audit, however. Packman says that one of the most important things you can do in dealing with the IRS is to be proactive during the examination. While an examiner will wait while you pull out paperwork and trying to figure out answers to questions, if you can prepare for the examination, you can make it a lot less stressful. You can even consult with your CPA to make sure you know the correct numbers as a way to prepare.

Packman has some specific suggestions on how to get ready for an IRS examination.

All payroll records should be organized and set in a clear order for the IRS including W-2s issued, W-3 transmittal forms, 1099s issued, and 1096 transmittal forms. The small business should be able to explain how compensation was determined. Note that even if payroll and employment taxes are not issues initially identified by examiners, examiners are required to perform compliance checks on these issues under IRS package audit requirements. The business owner should also review their depreciation schedules and procure evidence of their initial purchases of depreciated items to help establish the depreciation basis. If the business owner has inventory, he or she should ensure ending and beginning inventories were taken for each year and spot check them to ensure their accuracy. Finally, the business owner must be able to explain how gross receipts were calculated and how cost of goods sold (if any) were calculated.

While an audit is not a pleasant process, it tends to be easier to manage it if you can approach it calmly. An audit is not necessarily a problem, especially if it's just a matter of your name coming up during the random selection process. Keep your cool and an audit will often go much faster.

The Option to Appeal

Unfortunately, sometimes a tax problem goes beyond a simple audit. If an IRS examiner finds a problem with your tax return, the best case scenario is needing to file an amended return. The worst case scenarios involve penalties and fines. It is important to remember, however, that at each step of the resolution process, you have rights as a taxpayer. You can request an advocate through the Taxpayer Advocate, as well as dispute decisions made by the IRS through the Office of Appeals. The Office of Appeals is independent of all other IRS offices and offers impartial reviews of tax decisions.

It's important to decide whether to appeal a decision before signing an agreement with the IRS: in order to resolve many common problems, the IRS will offer an agreement on how to proceed. If you sign that agreement, you are expected to complete it and will not be eligible for an appeal. However, appeals are not necessarily offered as an option in all tax problems. In situations where the facts are not under dispute, but rather a taxpayer's ability to pay, the Office of Appeals will not consider the case. In such situations, payment plans are often available.

Working with a Tax Professional

If you do wind up with a tax problem, it's almost always best to find a tax professional who can guide you through the process of solving that problem. During a standard audit, that professional may be the CPA who's been working on your business' finances all along. For something more complex, it may be better to seek the help of an attorney specializing in tax law. Considering that even members of Congress can't seem to get every last part of their taxes done correctly, it's important to have an expert in the field to help out.

While most state tax bureaus don't create quite the sense of dread that the IRS manages, they typically can cause similar problems for businesses. Similar tactics tend to work for minimizing problems with your state tax bureau, though. If you can keep calm throughout the process, as well as find a tax professional to work through the bureaucratic snarls, you can come out in one piece on the other side.