© 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 labor.

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.

Representative's Role

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 deductions area.

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 few items.

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.

Be organized.

Give them only the documents needed to support the deduction being questioned.

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.

Bottom Line

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, or destroyed?

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!"

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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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