A few years ago, Tim and Tracey Kerin of Damascus, Maryland, got the letter many business owners dread receiving: The IRS planned to audit one of the couple’s five businesses, a commercial cleaning company, for tax year 2009.

But what started as a seemingly straightforward audit of the single company’s expenses spiraled into a lengthy audit of two more of the Kerins’ businesses, along with their personal tax return. Now three years later, Tim says the couple has spent about $95,000 on attorney and CPA fees, which he fears will eventually reach $110,000. Tim and Tracey had to lay off a few managers and sell two vehicles in order to cover their legal and accounting fees.

“It’s been an incredibly stressful experience,” Tim says. The auditor was questioning expenses that the company reported, and, as Tim puts it, “wanted to see every single invoice from our suppliers, our employee records, every expense receipt, mobile phone records.” Tim says the audit stemmed from some questionable expense deductions a former accountant had claimed on their tax returns. 

Uncle Sam Wants You!

Whatever the reason, getting audited by the IRS or a state tax department can be one of the most stressful experiences a small-business owner can face. Depending on the depth of the investigation and how well prepared they are, business owners can spend hundreds of hours gathering documentation and expense receipts to fulfill the auditor’s requests. And while hiring an accountant or tax attorney to manage the audit process can help relieve the business, it can also mean racking up tens of thousands of dollars in fees.

“Every audit is completely different,” says Vinay Navani, a shareholder at Wilkin & Guttenplan PC in East Brunswick, New Jersey. “It’s like trying to figure out the secret formula to Coca-Cola.” Nobody knows exactly what to expect before it happens to them.

Unfortunately, it’s very difficult to know whether your business is vulnerable to an audit. Some businesses are selected randomly for audits, while others are audited due to specific concerns or “red flags” that the IRS spots on returns. The IRS has long been tight-lipped about how exactly it determines which businesses to audit. However, more information has emerged in recent years about the selection process.

For example, the IRS scores each tax return using a confidential computer program. Returns with higher scores are more likely to be audited. Some of the factors that can trigger a business return’s high score: claiming deductions that are unusually large in relation to income, discrepancies between the return and tax documents such as W-2s and 1099s, and reporting large business losses.

Overall, the odds of getting audited by the IRS are actually rather low. According to the IRS 2012 Data Book, the agency audited just about 1 percent of all individual tax returns. However, it audited 3.7 percent of all individual returns with more than $200,000 in income—which could include many sole proprietors who file a Schedule C—and about 12 percent of individual returns with more than $1 million in income. It audited 1.6 percent of corporate returns overall, but 17.2 percent of returns for corporations with more than $10 million in assets. Only 0.5 percent of partnerships and S corporation returns were audited during the same period.

But the IRS’s audit process changes over time. Faris Fink, head of the agency's Small Business/Self-Employed Division, told attendees at the American Institute of CPAs’ National Tax Conference last year that the IRS plans to focus more of its attention on examining partnership returns, because those types of businesses have become more complex over the years and are therefore more susceptible to fraud.

In recent years, certain states, such as California, Connecticut and Illinois, have increased the number of audits they're conducting, partially because they have the technology to gather better information on businesses and individual taxpayers, according to MarketWatch.com.

From Start to Finish

Each audit is completely different, and much depends on what the auditor feels is necessary to determine whether the return in question is fully accurate. To get the process started, the IRS generally first sends a letter to the business stating its plans to conduct an audit of a certain year or years' tax returns.

A business’s initial meeting with an auditor generally includes an interview in which the auditor questions the business owner or their accountant about the returns under investigation. He or she will then ask the business owner to provide documentation to verify specific information on the tax return. That data can range from expense receipts and property records to auto mileage logs and utility and credit card statements.

For some business owners, this level of inquiry can be frightening and entail hours of digging up and tracking down documents—especially if they haven’t kept detailed records.

Mary Baier, owner of a small financial services firm in Jersey Shore, Pennsylvania, says she had her first meeting with an IRS auditor in 2010 about her 2007 tax return. The auditor asked detailed questions about everything from the equipment Baier's husband uses on the couple’s farm to life insurance policy medical bill information. Baier says the auditor indicated that her business’s expense deductions seemed too high compared to her and her husband’s reported income. The auditor, Baier says, “questioned the fuel we use on the farm. She questioned my mileage—everything down to postage.”

Baier estimates she spent more than 50 hours pulling together all the documentation requested by the auditor, including full credit card statements, letters from her doctor verifying visits and procedures, and phone records. “I’m here trying to run a small business on top of trying to get her all this information,” she adds. The auditor eventually decided to expand the audit beyond 2007 and include the 2008 and 2009 tax years.

But even when audits go smoothly, they can still be time consuming. Standard audits can last anywhere from a few weeks to several months to many years. Pierre Zarokian, CEO of SubmitExpress.com, a Burbank, California, search engine optimization firm, had his 2008 to 2012 tax returns audited due to a deduction error he says was made by his former accountant.

Zarokian spent $20,000 to hire a tax attorney to help him navigate the audit. But the IRS still wanted to see a lot of documentation that Zarokian estimates he spent 50 to 100 hours digging up himself. “They were asking for records of business sales, bank statements, transaction records, purchase agreements and tax returns,” Zarokian says. “It was a lot of research.”

The whole process took about a year, Zarokian says. In addition to the attorney's fees, he also had to pay thousands of dollars in extra taxes due to the incorrectly claimed deduction.

It Ain't Over Til It's Over

What happens once the audit is finally complete? The auditor puts together an audit examination report that details the findings. This includes how much, if anything, the auditor thinks the business owes in back taxes and penalties. The business can either agree to the findings and sign the examination report, or it can dispute them by either going through the IRS's Fast Track Settlement program or by filing an official appeal.

Baier, for example, was told that she and her husband owed about $36,000 in back taxes after their audit. They tried several times to appeal the decision, to no avail so far. Though Baier disagrees with that assessment, she ended up taking out a loan to cover the bill because she didn’t want to rack up interest charges.

The IRS can also levy extra penalties on businesses that it finds have errors in their tax returns. However, an auditor may decide to dismiss or lower those penalties if he or she chooses, Navani says. That’s a good reason for business owners to try and stay on good terms with their auditor. As Navani says, “The best thing you can do is create a good relationship with your auditor.”

Prepare Yourself for the Worst

Though the audit process can be painful, tax experts and business owners who’ve been through it say there are ways to make it less so. Here are three smart tips:

1. Keep highly detailed records from the get-go. One of the most common headaches of an audit is tracking down the documentation that's needed to back up information on the tax return that’s being examined. Business owners who keep detailed, organized records—including original or electronic receipts of all their expenses—will be in a much better position during an audit than those who need to dig through piles of paper or, worse, contact all the places they spent money to track down necessary documentation.

Since many auditors request to see old expense receipts—particularly meals and entertainment receipts—it’s a good idea to write down on the receipt the business purpose of the expense along with any key details (such as who the business meal was with). You should then file the receipts by year and expense type, so it’s easy to pull them in case of an audit.

Similarly, a business should keep copies of its tax returns dating back at least five years and any invoices, property records, employee records and other data that factors into the information listed on the tax return. “I’ve seen great audits, and I’ve seen nightmare audits, and it comes down to how organized the small-business owner is,” Navani says. “It all comes down to documentation.”

Jeff Kear, co-owner of Planning Pod, a Denver--based online event management software company as well as another small business, said he and his business partner keep all their accounting records in Intuit’s QuickBooks. So when the company got audited for tax year 2011 in early 2012, they were able to quickly pull much of the documentation needed. For instance, the auditor wanted to see a profit-and-loss statement for both of the businesses, which was “quite easy” to pull together, thanks to QuickBooks. However, Kear admits that finding receipts on a few items the auditor requested “was a little challenging.”

The audit lasted just one month from the company’s first meeting with the auditor through when Kear and his partner received the auditor’s decision. The company ended up not owing any back taxes or penalties.

“We try to document everything and save [receipts electronically]," Kear says, "so if anything like this comes up, we’re pretty well set up when it comes to documentation."

2. Consider getting expert help. Having your company’s accountant help you navigate an audit may well be worth the cost, especially if the auditor’s inquiry is complex. If the audit turns particularly contentious, you may even want to consider hiring a tax attorney who's highly familiar with the IRS’s audit procedures. Be prepared to pay a pretty sum for that expert help, however. An accountant may charge a few hundred dollars an hour for their services, and it’s not unusual for such representation over the course of an audit to cost you thousands of dollars in fees.

After initially meeting with the auditor, Kear and his business partner hired their CPA to handle much of the audit process. The CPA put together a binder with all the information the auditor needed and served as a point person for any questions the auditor asked. Kear estimates the accountant saved the company at least two weeks of work. However, hiring her cost them about $3,000.

“It’s not a cost we were expecting to have to pay,” Kear says, but it ended up being well worth it. The accountant was able to guide Kear and his partner through the process and gave them a lot of useful advice about how to manage their company’s finances.

“The lesson we learned is, hire a good accountant,” Kear says. “They’ll be able to tell you ahead of time ‘Stop doing this particular practice you’re doing because it’s going to raise red flags.’ They know exactly what the IRS is going to look for.”

3. Be careful filing your tax return. Businesses often get audited because they made errors on their tax return or got overzealous claiming tax write-offs they don’t have documentation to back up. Being careful to accurately report income and claim deductions can go a long way in ensuring your return won’t be flagged for an audit, Navani says. Many do-it-yourself tax preparation programs include features that help business filers review their returns for any potential errors or issues that might raise eyebrows with the IRS.

And even if you hire an accountant or other tax professional to prepare your taxes, it’s important to review your return and have a firm understanding of your business's financials, income and deductions, Kerin says. Unfortunately, he and his wife learned that the hard way.

“This has been a total nightmare for us," Kerin says, "but we’ve learned, as business owners, that we’re the ones ultimately accountable.”

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