Staring at the envelope won’t make it go away—you're just going to have to buckle down and open it. Getting ominous-looking mail from the IRS can be stressful for a business owner, but ignoring an audit request is even worse.
If you're the target of an audit (sometimes also called an examination), chances are, it will start with a letter. It might also end with a letter, since statistically, most examinations conducted by the IRS are correspondence audits.
Those types of audits are also referred to as “on paper” audits because in most cases, you aren’t actually required to meet face to face with an IRS agent. For fiscal year 2011, the last season for which data is available, correspondence audits outnumbered field audits by a ratio of nearly three to one. And there’s good reason: They tend to be faster and less expensive than field audits.
Field audits—or “in person” audits—tend to be more focused and generally involve a significant dollar amount. They're also often targeted at higher income taxpayers. In 2011, field audit rates for taxpayers with income starting at $200,000 increased by 34 percent over the prior year. In the same time period, taxpayers with incomes of more than $1 million faced even greater odds (1 in 8).
Most of the time, in the case of a correspondence audit, the IRS is simply requesting more information. Maybe your 1099 forms don’t match the forms received by the IRS, or maybe the IRS wants to see receipts for those section 179 expenses.
If that’s the case, there’s usually a pretty simple solution—assuming you have the information handy. If you don't and can’t meet the deadline, ask for an extension. You can usually get between a two-week and 30-day extension simply by asking, assuming you have a valid reason. As a tax attorney, I’ve never had a client turned down when they had good cause.
If the examination asks for a lot of information—or if there’s the dreaded request for an interview—it’s likely time to consider representation. Be careful, however: The pool of professionals who are authorized to represent clients before the IRS is limited and generally includes attorneys, certified public accountants, enrolled agents, enrolled actuaries and enrolled appraisers.
Taxpayers often worry that bringing in a representative can appear to be an admission of guilt. But that’s not the case. In fact, the IRS often prefers to deal with a representative because a tax professional understands what the IRS is looking for—as well as what they might not be looking for.
Even more important? A tax professional will approach an audit completely differently from a taxpayer, so there’s less chance of conflict, drama or over-emotion. It’s not personal, and that’s a good thing. The agent doesn’t want to hear all the reasons why an audit isn’t fair or how terrible you felt all year. Although details about your circumstances might be important in the calculation of penalties or for purposes of appeals, they don’t generally change the nature of the initial information request.
And that’s perhaps where taxpayers can go terribly wrong: They like to overshare. Audits can be high pressure situations, and that sometimes leads to loose tongues. While the information you're sharing may be well-intentioned, an audit isn’t a confessional.
You should simply answer the questions posed by the agent without offering any extraneous details. That time you stole from the collection plate in junior high? Or ran that stop sign a week ago? The IRS really doesn’t care. And baring your soul, even out of nervousness, may lead the IRS to rethink your character.
Sometimes taxpayers take the other route, choosing to hide information from the IRS. That’s also a mistake. If you’re worried about whether to reveal certain details, ask your tax professional. It’s better for your tax professional to have all the facts and edit according to the questions asked rather than be caught by surprise—that doesn’t make anyone look good. That secret bank account you didn’t reveal to your tax professional? The IRS probably knows about it. That second set of books that even your wife didn’t know about? The IRS probably knows about that, too.
Smart Moves to Make
Realistically, most audits are targeted, which means the agent likely knows exactly what he or she is looking for—it’s not a fishing expedition. There may be a list of deductions the IRS intends to deny or income that the agency feels has been under-reported. So be smart: The audit is your opportunity to explain any inconsistencies or discrepancies between what you reported on your return and what the IRS expected you to report on your return.
Give yourself plenty of time to answer questions and present information in an organized fashion. I’ve never approached an audit without a spreadsheet in hand because I don’t want to give the IRS an incentive to dig through my clients' financials for more details. If the IRS asks for bank statements, give them bank statements organized by bank account and by month with a spreadsheet summarizing all the data, annotated if there’s anything out of the ordinary.
Making the agent’s life easier tends to result in a more seamless audit. Handing over a messy stack of papers or trying to be tricky just opens you up to more inquiries. That’s what you don’t want.
Finally, keep in mind that an audit isn’t your last chance to defend your position. Once the audit is over, the agent will make a recommendation about any taxes and penalties (keep in mind that interest is statutory and, in most cases, not negotiable). You can choose to agree with those findings or appeal. If you don’t agree with the appeal, you can always try your hand a third time in tax court.
Nobody wants to be audited, but if you are, don’t make it harder than it needs to be. Be organized, be polite, and be cooperative. Most important, be smart. And sometimes, being smart means knowing when you’re in over your head. If that's the case, don’t be afraid to ask for help. It may just be the smartest move you can make.
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Photo: Cassandra Hubbart