With April 15th in the rear-view mirror, most taxpayers thought they were through with the IRS for another year. Then a letter comes in the mail – you’re being audited. Now what do you do? First breathe deeply and consider the following:
What sets off an audit?
Audits are most often triggered by the type and amount of deductions taken. For individuals, this includes large charitable contributions, employee business expenses and any other large losses listed on the tax return.
In addition, not including income reported on a 1099 Form is a common audit trigger. The IRS uses a matching process to match W-2s, 1099s and various others tax forms. Omitting a form will likely generate an IRS notice or audit.
Businesses reporting high deductions and low income are also commonly audited. Tax professionals have long known returns that include a Schedule C are the most likely type of returns to be audited. The Schedule C is used by a business operated as the taxpayer, not a legal entity such as a corporation or LLC.
We don’t see many audits with our business clients. However, some recent audits occurred when the taxpayers filed a Schedule C reporting expenses and little income. We watch for these returns and discuss the possibility of an audit. Areas where we’ve seen scrutiny during recent audits are verification of gross receipts, travel and entertainment expenses and vehicle expenses. It’s a good idea to discuss alternatives to filing a Schedule C with your CPA.
Type of audits
There are primarily three types of audits:
Correspondence audit: With a correspondence audit, all communications are performed by mail. The IRS asks for a straightforward answer on the issue under audit, such as proof of deduction, and the taxpayer provides the answer by mail. Correspondence audits are generally limited to one or two issues on a tax return.
There are two difficulties with a correspondence audit; no opportunity to discuss issues with a live person and timing for providing the requested information.
It can take several mailings to address complex issues and to reach correct conclusions. I have found discussing issues, scheduling deadlines, reaching agreements and other aspects of the audit are much easier to resolve through a live conversation with the auditor. The personal aspect is lost when the audit is performed by mail.
The time delay relating to sending and receiving mailings can also be problematic. It may take several weeks, after receiving a response, for the IRS to associate the response with the audit file. Then it may take as many as 60 days or longer to review response. During this period, the taxpayer may receive a series of tax due notices. It is very important to follow up on all notices and sometimes resend information. A correspondence audit is not always the simplest form of audit.
Office audit: Office audits are conducted at a local IRS office. The agent will ask the taxpayer to produce receipts and other documents related to specific questions about the tax return. The audit can expand to other issues if a taxpayer is unable to provide the appropriate documentation. During an office audit, the agent will focus on overall business purpose for expenses and will require substantiation and proof of payment for these expenses.
This is increasingly more difficult with electronic bill pay and paperless invoices. We were recently working with an IRS agent and were asked to provide check copies as proof of payment. We explained the taxpayer hadn’t issued a check for several years. The payments were made electronically using debit and credit cards. It seems the IRS is behind the electronic-times with their requests and need update their requests to align with new technologies.
Regardless of the methods of payment, it’s the taxpayer’s responsibility to keep receipts and proof of payments. It’s much easier to develop a record keeping system on the front end, then to rebuild records during an audit. It’s especially important to keep receipts for travel, meals and entertainment expenses. Makes note on the receipts with whom you met and a brief purpose of the meeting. These records are the most difficult to recreate.
Another very common area of scrutiny is vehicle expenses. Be certain to keep mileage logs or other proof of business miles and expense.
During the preparation of your tax return, work closely with your tax advisor to prepare a complete tax return file. Be aware, most tax preparers don’t maintain files that include all the documentation needed. It’s typically the taxpayer’s responsibility to keep receipts, bank statements, credit card statements and other proof of payments.
Field audit: A field audit is the most comprehensive review of a taxpayer’s financial records. The field audit is performed by inspectors on-site or at the office of an authorized representative. In most cases the inspectors will review all the financial records that related to the tax return under audit.
A field audit is the least common and most intrusive type of audit. The IRS announced it will perform approximately 525,000 field audits during 2016. If you are unlucky enough to be chosen, it’s smart to engage a CPA who is experienced with IRS audits.
An experienced tax professional can help in a number of ways and is trained on how to discuss and resolve a case with the IRS. Work with someone you are comfortable talking to. It’s best to have someone who understands you and is able to explain what you did and why you did it.
Some important points:
Ask for more time if you need it. Don’t meet the IRS unprepared.
Don’t host the IRS. It’s best to have your representative host the meeting.
Prepare your records. Make sure to include receipts and proof of payment.
Manage expectations. Strive to agree on changes, if needed, and manage your emotions.
Don’t elaborate. Answer questions directly. Simple answers are best.
Be honest and build trust with the auditor.
Know your rights. The taxpayer can discuss findings with the auditor’s manager when needed.
Time is on your side. Don’t rush to finish. Work at the pace that makes sense for your schedule without intentionally causing delays.
If you don’t agree, appeal the results. Work out differences with the auditor or manager if possible. If agreements can’t be reached, you have the right to appeal the result.
An IRS audit can be stressful, time consuming and costly. Maintaining a good record keeping system will help you be prepared in advance. Look for audit flags when the tax return is prepared. Make sure you spend extra time supporting larger or unusual deductions. Finally, if you are chosen for an audit, ask for help. A qualified CPA will help reduce stress and ensure you get to the proper result.
Matt Lee is a shareholder at Opsahl Dawson, a Vancouver-based CPA firm. He can be reached at email@example.com.