How to Survive an IRS Audit
The mail gets delivered to your office and you immediately see the return address on the letter is from the Internal Revenue Service. You check the addressee and it is definitely addressed to you. Your heart starts to beat faster and your worst nightmare is about to come true: an IRS audit. The letter states that the IRS wants to examine your tax return which is followed by what seems to be an endless list of information you will need to provide to the IRS auditor.
Should you receive one of these letters, the initial step is to contact your accountant. Chances are he or she has been through the process before. Your accountant should help ease any of your anxiety. If you choose to have your accountant handle the matter, then have him or her contact the IRS to arrange a time and place for the audit. It is always best not to have the IRS auditor perform the examination at your place of business because he or she may then be privy to information or conversations that may give the auditor reason for additional investigation. If possible, have the examination performed at your accountant’s office. The IRS auditor may still request to visit your office to be sure it actually exists.
During the initial conversation with the auditor, it is beneficial for you or your accountant to ask why your tax return was selected for examination. The answer may provide you with some insight into the area of your tax return that the auditor will be focusing on. Many times, however, the auditor will tell you it was a random selection.
Once the date and place are agreed upon, it is time to compile the information requested by the auditor. This task can be incredibly easy, or excruciatingly difficult, depending on the level of organization of your business records; most are somewhere in between. [Sidebar: Using a computerized accounting system and keeping digital copies of your receipts for seven years can make this process much easier.] Most likely, the auditor will want a copy of your general ledger. The auditor will want to use this to select areas of your financial records to test. The auditor will test these areas by requesting documentation of your expenses, usually requesting invoices to match the expenditures reported on the tax return. Additionally, the auditor will request invoices for capital expenditures such as equipment or leasehold improvements.
Gathering and organizing the requested information is clearly the most important step in the audit process. Your goal should be to compile all of the requested information in a complete and organized fashion. Most importantly, be aware of possible overstatements of expenses and understatements of income.
Once you have gathered the requested information, it is very important that it is presented to the auditor in a clear and organized manner. This is one case where the book may be judged by its cover. If the information is provided to the auditor in an unorganized fashion, he or she may assume that your record keeping is not accurate. This may create cause for additional testing.
You should also take time to compare your financial records to the tax return that is under examination. Many times the financial records no longer tie into the tax return because adjustments were made subsequent to the original filing. If they do not match, the auditor will immediately become skeptical of the accuracy of the financial information you are presenting. Performing this type of “self audit” can give you valuable insight into the accuracy of your practice’s records. It will also give you time to reconcile or support all of the differences, before you meet with the auditor.
There are two theories when meeting with the auditor. The first is to not let the auditor the least comfortable as possible, so he or she will leave the office as early as possible. The opposing view is “kill’em with kindness.” Put the examiner in a comfortable setting where he or she can complete the audit. The former is more of a myth than a reality. The examiner needs to complete all of the procedures, and the condition of the space provided will, most likely, not influence the result and may have the opposite effect. Therefore, it is advisable to treat the auditor as you would any guest in your or your accountant’s place of business.
You and your accountant should also be present at the initial audit meeting. This will consist of the auditor completing a lengthy questionnaire with your input. The questionnaire is used by the auditor to understand the accounting methods used to track income and expenses for your practice. In this meeting, you should act as if you are a witness on the stand in a legal trial and only answer the questions that are asked, with factual information that is relevant to the question. If the question requires a yes or no answer, than that is how you should respond. Many times, individuals elaborate on the questions asked and the auditor uses this information to expand their audit to additional areas where they may suspect issues exist. Your accountant should answer as many questions as possible. The accountant’s training and experience provides an understanding as to why the questions are being asked and the truthful answers that will not raise additional issues.
After the auditor has completed the audit of the materials and information provided, he or she will meet with you and your accountant again. At this point, you will be able to respond to any identified issues. You should make every effort to locate information that will satisfy the auditor’s preliminary findings. You may not be able to find the specific invoice or bill the auditor requested. Therefore, you need to determine if there is other information that may appease the request. For instance, if you are missing an invoice for the purchase of medical supplies, you may be able to present the delivery slip or a duplicate invoice obtained from the vendor. It is always easier to resolve issues with the auditor rather than with his manager or an appeals officer. Thus, you should make every effort to continue the dialogue with the auditor to determine if there is any other information you can provide to satisfy the questions raised.
Depending on the final findings of the auditor, one of two things will happen: you will accept the findings or challenge them. Either way, you will have survived the initial audit. Keep in mind, good accounting practices and organized records will make an IRS exam much easier to survive. As they say, an ounce of prevention….
About the Author: Michael J. Kline is a Certified Public Accountant. A partner in Citrin Cooperman’s Philadelphia office (www.citrincooperman.com), Kline is responsible for client service and quality control, and consults with clients on issues including ownership structure, entity decisions, audits, and multi-state tax and succession planning. Kline can be reached at firstname.lastname@example.org or 215-545-4800.