- A tax audit is when the IRS examines your tax return information to ensure all the reported data is correct.
- There are four kinds of tax audits: field, correspondence, taxpayer compliance measurement program and office audit.
- Incorrect data or incomplete tax returns can trigger an audit.
- This article is for small business owners who want to learn the best ways to avoid a tax audit and what they should do if they receive an audit notice from the IRS.
One concern for many taxpayers is the possibility of being audited by the IRS. A tax audit is an examination of an organization's or individual's tax return to verify that financial information is being reported correctly.
While the chances of being singled out for closer scrutiny are statistically low, some factors could increase your odds of being audited. Fortunately, there are measures you can take now to minimize the likelihood that you and your business will be audited by the IRS.
What triggers an audit?
A variety of potential "triggers" in tax returns tend to raise questions and attract unwanted attention from the IRS. The IRS uses a computer scoring system, called the Discriminant Information Function (DIF) system, which analyzes tax deductions, compares taxpayer data and is often the basis for initiating an audit.
- Issues can crop up when income is not fully reported, or business operating losses are considered unusual.
- Other triggers include errors or inconsistencies in the return, omissions, lavish business expense deductions for meals and entertainment, and a sharp drop in reported income from one year to the next.
- Exceptionally large charitable deductions can sometimes trigger an IRS audit, but they're usually allowed when a taxpayer has receipts and documentation to back them up.
- Making a lot of money can also be a red flag. "The majority of tax returns that are audited belong to taxpayers whose income is more than $500,000, or over $1 million a year," said, Adriene Raynott, a senior business analyst at Cogneesol. "And the chances of audit increase when taxpayers try to wipe out their income through tax deductions."
- Another item likely to prompt the IRS to dig deeper is having money in a foreign bank account.
- Examiners also pay closer attention to cash-intensive businesses such as restaurants and convenience stores, which generate a lot of cash receipts from smaller transactions. [See Related Story: Getting Audited? How to Handle It Like a Pro]
Although most business owners and other taxpayers cringe at the idea of having to defend their tax return in an IRS audit, there's usually little reason to worry. In its 2015 Data Book, the IRS reported that 72.6% of audits were resolved via correspondence, rather than face-to-face meetings. The remaining 27.4% were conducted in the field (at the taxpayer's place of business or CPA's office) or at an IRS facility. While nearly 1.4 million tax returns were examined, that number represents less than 1% of the more than 150 million individual returns received and processed every year.
Scott Berger, a CPA and principal at the Boca Raton, Florida, office of Kaufman Rossin, said the IRS is moving more toward correspondence audits, which can impact individual taxpayers, small businesses and sole proprietorships. With this type of audit, the taxpayer receives a notice from the IRS saying that the agency is examining a tax return and has questions about specific line items. The purpose of the notification is usually to request supporting documentation for the line items being questioned.
Key takeaway: Several factors can trigger an audit, like an incomplete tax return, incorrect information on your tax documents, large charitable deductions, or having money in a foreign bank account.
How to minimize your risk of a tax audit
According to Berger, one of the best ways to reduce your chances of being audited is to keep detailed records. This ensures that if you are questioned by the IRS, you can substantiate deductions, income and other information. He recommended organizing bookkeeping systems to create a clear and accurate record of all transactions as well as maintaining and preserving the source documents used for accounting and tax preparation.
"The other thing I would recommend that somebody do is hire a bookkeeper," said Berger. "Look at what it's going to save you, not what it's going to cost you."
With the assistance of a knowledgeable bookkeeper or tax preparer, "issues will be vetted before they're presented on a tax return," Berger said. Accounting and bookkeeping professionals can also help substantiate and validate information reported to the IRS, he added.
Key takeaway: To avoid being audited, keep organized records of your finances using a bookkeeping or accounting system. When filing taxes, work with a tax preparer to ensure your information is reported correctly.
What to do if you receive an audit notice
Berger and other tax professionals said they generally advise against communicating directly with the IRS if you receive an audit letter. Berger said his clients often tell him that because they have nothing to hide, they want to call the IRS and let them know that. Based on his nearly 30 years as a CPA, Berger thinks that's a bad idea.
"Generally speaking, nothing good ever comes out of that," he said. "Yes, they have nothing to hide; the return is all on the up and up, but this person on the other side of the phone has a job to do, and their job is to make sure the government collects all the taxes that it legitimately can."
Berger also cautioned that IRS audit letters are always sent by postal mail, so phone calls or notifications sent via email are invariably scams.
Martin Press, a tax attorney with Gunster law firm, agrees that clients should not represent themselves in tax audits. As soon as a small business owner receives an audit notice in the mail, they should immediately contact their CPA and provide him or her with a signed power of attorney form ( Form 2848), he said. This authorizes either a CPA, tax attorney or enrolled agent to contact the IRS and handle the audit, without the taxpayer needing to be present. He also said the audit examination should be held at the CPA's office and not the taxpayer's place of business.
Press said clients are always relieved when he informs them that they do not have to appear before the IRS – either initially or at any time down the road.
"The IRS, many times, claims that they have to start out with an interview of the taxpayer," Press said. "There is no obligation for a taxpayer to do an interview at the beginning of a tax examination. Under what we call the Taxpayer Bill of Rights, they may never have to give an interview with the Internal Revenue Service."
Although taxpayers are not required to meet directly with the IRS, an examination of a small business taxpayer is usually not over quickly; it often takes a minimum of six months to a year to resolve, Press said. If no resolution is reached, however, or if taxpayers wish to dispute the outcome of the initial audit, they do have a right to appeal it.
Statistics released in the IRS' 2015 Data Book show that a relatively small percentage of audited taxpayers decide to pursue further action. "Of the almost 1.4 million examinations of tax returns, nearly 28,000 taxpayers did not agree with the IRS examiner's determination," the report said.
Key takeaway: If you are audited, do not handle it by yourself. Contact a certified public accountant or tax attorney to represent you. Resolving this issue can take from six months to a year, depending on your case.
Types of tax audits
All tax audits are not the same. The one you encounter depends on your situation, what the IRS gathered from your tax return and the items that are needed to resolve the issue.
"The IRS selects returns for correspondence, office and field audits using return selection software," said Dewey Martin, a certified public accountant and professor emeritus at the Husson University's School of Accounting. "Details about this software are not available to the public. The software compares deductions and losses to income sources on filed tax returns to find outliers."
1. Correspondence audit
In this case, you will receive a direct order or letter from the IRS requesting a proof of statement or documentation that will help them verify the information reported on your tax return. Martin said this is the most common type of audit, and you're likely to receive this letter if you have a high level of charitable contributions compared to income.
"I had a client who was audited on this issue using the correspondence audit because the contributions were higher than her income," Martin said. "Once documentation was mailed to them, there were no changes to the tax return. "
2. Office audit
This is when you have an in-person meeting with a tax auditor at an IRS office. This occurs when there are several issues on your tax return that a correspondence audit won't fix.
"Sometimes this happens because a business operating as a proprietorship has some unusual transactions," Martin said.
3. Field audit
This is a face-to-face meeting with an IRS auditor. In this case, they come to your CPA's or tax attorney's office (or, if you insist on handling things yourself, your place of business or home) to hash out the details of your tax return.
"If there is inventory involved in the business, the auditor will usually want to observe the actual inventory and review inventory records at the business location," Martin explained.
4. Taxpayer Compliance Measurement Program audits
This is when IRS auditors examine every item and event in your life that they feel can affect your taxable income. This is a rare audit and may require you to show your birth certificate, marriage license and other personal documents. Their goal is to check that all the paperwork you provided is actually from you.
Key takeaway: There are four types of tax audits; correspondence, field, office and tax compliance measurement program audit. Each one varies in degrees of verification required to resolve the issues in question on your tax return.
Additional reporting by Joel N. Sussman. Some source interviews were conducted for a previous version of this article.