What To Do If The IRS Audits Your Tax Return
© by Greta P. Hicks, CPA
If you receive notice that the IRS is auditing your business, don't
panic, talk to the auditor only enough to refer him/her to your tax professional,
and get organized.
Just because your income tax return has been selected for audit,
doesn't mean "they are out to get you". It could mean that the
computer has selected your number for audit. Perhaps, your business is
part of a program to "test" compliance in the industry. Maybe
a competitor or disgruntle employee "squealed" on you. The IRS
is suppose to tell you why your return was selected for audit.
Why Did Your "Number" Come Up?
When income tax returns are filed in the IRS Service Center, the
information on the return is put into the computer. Each return is assigned
a numerical score that is arrived at by determining how far above or below
the average each of your deductions are. Each deduction that you have taken
that varies from the norm is added together and the total amount determines
your numerical score.
The scoring system is a secret but experience tells us what makes
the score go up:
Low gross profit margin
High auto expenses
High business use of autos
Number of autos used in business
High travel and entertainment
Little or no profit from business operations
Recently, interest expense has become a high-risk audit item. In
1986, the deductibility of personal interest began to be phased out. The
IRS is auditing interest on businesses to assure that it is business and
not personal interests. Before long, they will be enforcing those complicated
"interest tracing rules."
The higher the number, or the more your deductions vary from the
norm computed by the IRS, the greater the chance of error on the return.
Therefore, returns with higher numerical scores are the ones more likely
to be audited.
You Ought To Know
It is also your prerogative to ask why your return was selected for
audit. Even though the bulk of the returns audited are selected because
of a high numerical score, other criteria for selection include informants,
your relationship to another taxpayer who is being audited, being part
of a special groups that has been singled out for auditing, or being part
of an IRS project such as the auditing of all employers who use contract
Kinds Of Audits
There are four kinds of IRS audits.
Correspondence Audit is a letter from the IRS Service Center requesting
that you send in copies of your canceled checks and/or receipts in order
to verify certain deductions on the return. This type of audit is reserved
for small, simple tax returns and most likely your business will not be
audited in this manner.
The notice of an office audit also arrives by mail. The letter identifies
specific items on the return that are in question and requests that you
or your representative to bring certain documents to the local IRS office
for the auditor's examination. If your business is a small, sole proprietorship
with sales under $500,000, you may be subjected to this type of audit.
With a Field audit, the IRS agent, personally, will call the owner/president/general
partner and notify him/her that the return has been selected for audit.
This type of audit is called "field" audit because the agent
will want to conduct the audit at your place of business rather than the
IRS office. Most incorporation businesses and partnerships are audited
in this manner. During the initial telephone contact, the agent will be
asking for the following:
To interview the principals
To arrange a date(s) to be at your place of business
To determine where the records are located
To provide a list of records that are to be made available
It is crucial that during a field audit, you have representation.
The IRS agent is instructed to interview you and go to your business so
that he/she can ask detailed questions about business operations and see
the business facility first hand. We who handle IRS audits regularly call
this a "fishing expedition." Your representative will attempt
to buffer you from this type of questioning and probing. More than likely,
your representative will attempt to have the audit conduction in his/her
office rather than your business.
The overall goal of your representative will be to handle the audit
in such a manner that your "exposure" is decreased. By exposure,
we mean the risk that the agent will probe into the areas will your business
is vulnerable, where the high risk items are, or where the most questionable
Because the laws are subject to interpretation, there is no such
things as a "perfectly" correct tax return. A representative
can conduct the audit in such a manner as to "limit the agent's scope"
or limit the amount of information the agent sees or requests to examine.
One agents definition of "material" deduction will be $100
and the next will only look at items over $1000. Attempts should be made
to encourage the agent to have a high threshold of materiality which means
less documents you will have to pull from the file boxes. An agent who
dwells on small immaterial items if considered "picky" and can
be frustrating for your as well as your representative.
There is the risk that the agent will want to expand the audit into
prior or subsequent year tax returns or will want to audit related returns.
This should be discouraged because it increases your exposure and risk.
Every attempt should be made to answer the agent's questions and provide
documents in such a manner as to discourage the "mushrooming"
of the audit into other entities and issues.
The fourth type of audit is a TCMP audit, Taxpayer Compliance Measurement
Program audit. The primary purpose of this type audit is to update the
data used to write the scoring program. It involves a total audit in which
every part of the return must be substantiated by documentation. What this
means to you and your business is time.
A "regular" audit is time-consuming in that your staff
must find checks, invoices, contracts, bank statements, etc. for the items
selected for audit. In a TCMP audit, every line of the tax return is audited
therefore you have to provide documentation for all deductions not a selected
But, whichever one you may be confronted with, remember to stay calm
and get organized. For instance, pull all your canceled checks, receipts,
and other information related to the items to be audited and get that information
in sequential order. By providing the information to the agent/auditor
in an organized manner, it limits the amount of information that is exposed
to IRS scrutiny. Organized records also have a tendency to make the agent/auditor
think you are a "squeaky clean" taxpayer and may result in the
agent/auditor limiting their scope.
Timely Response To The Agent/Auditor's Request Is Crucial!
Timeliness makes it look as if you have nothing to hid and it limits
the amount of time the agent spends looking at your information. In both
instances, the risk of the agent/auditor finding a "mistake"
has been reduced.
Options For Handing An Audit
You can choose the handling the audit by yourself, have a representative
go with you, and have a representative go in your place. If choose to handle
the audit yourself or to have a representative accompany you, you increase
the risk that the agent/auditor will ask questions that you would prefer
not to have to answer. There is no such thing as idle conversation with
a person from the IRS. Each question has a purpose and that purpose it
to get information which will indicate that you have underreported your
income or over stated your expenses.
If your do choose to handle the audit yourself, here are some basic
do's and don'ts to follow.
Give them only the documents needed to support the deduction being
Never give the IRS agent more or less information than is requested.
Answer questions honestly, but briefly.
Never give the IRS the only copy of a document.
Do not leave your original records with the IRS.
Don't chatter or exchange casual conversation. Each comment only
gives them more information.
Stay calm! Don't be argumentative or belligerent.
Insist on getting copies of information in their files or copies
of anything that you sign.
- Better yet, wait until your representative has time to review the
document before you sign it.
How Can A Tax Advisor Concentrating
In IRS Problems Help?
1. AT THE BEGINNING
By consulting with an advisor up front, you can learn what
to expect from the IRS person, what questions that you will be asked, and
what documents they will require.
BE PREPARED! It is like any football game. Study the opponent and develop
a game plan accordingly.
2. IN THE MIDDLE
An attorney, certified public accountant, or enrolled agent can go
to the IRS audit in your place. Your representative is less emotional,
less defensive, and more able to negotiate on THE LAW. They speak
the same language as the IRS person.
3. THE END
Don't sign anything until you fully understand the document and agree
with what it says. If you want your CPA or tax consultant to see any document
the IRS asks you to sign, that is your prerogative.
Is The Decision Of The Auditor Final?
When the IRS agent/auditor presents you with a bill, you have the
option to agree and sign the document or disagree and request a hearing
with an appeals officer. The IRS is suppose to inform you of your appeal
rights and your representative is well versed in these matters. A part
of the up-front planning of an audit, is the discussion of the appeals
process and how best to make it work for you.
Whether your return was prepare by in-house personnel or a paid preparer,
you are responsible for it's contents. You need to review all tax returns
closely before signing them and mailing them to the IRS. Should the return
be selected for audit, how you or your representative handle the audit
will be determined by the following factors:
Your attitude toward the IRS - Is it hostile, defensive, one of fear,
or one of co-operation?
Items questioned - Has the IRS selected high-risk items or is there
risk that with additional probing the high-risk items will be "discovered?"
Personal and political pressures - Is your goal just to get the IRS
out of your life as quickly as possible?
Records - Are most records available or have some been lost, stolen,
MONEY - The cost to you in professional fees will be significant
but the cost in terms of time and stress will be greater to you if you
have no representation.
Less than 2 to 4 percent of the tax returns that are filed are audited.
If you number comes up, be prepared to get things organized and to present
your business in the most favorable light possible. A big part of handling
an IRS audit is communication and the ability to manage difficult personalities.
If you have these skills, you may want to handle the audit yourself. If
not, you may need a "hired gun!"
List of Articles by Greta P. Hicks, CPA
GRETA P. HICKS, CPA and former IRS manager, concentrates in solutions to IRS problems and advises business and tax professional on IRS policies
and procedures. Ms Hicks is owner of TAX SOLUTIONS, Inc., a company providing
educational materials and programs on solutions to IRS problems and is
a nationally known speaker and writer on solutions to IRS problems. To
arrange for consultation contact:
Greta's web site: http://www.gretahicks.com
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