Nothing strikes an emotional chord with small business owners like the prospect of a tax audit.
If you practice accurate bookkeeping and obey the tax laws, there’s little to worry about. It’s a matter of proving your company is in compliance. While the audit process may be intrusive, it’s within the IRS’s right to audit your tax returns.
When it comes to a field audit, start by contacting your tax preparer. If your return was prepared by someone other than a licensed public accountant, a certified public accountant or an enrolled agent, you should contact one of these professionals to determine the best way to proceed. Don’t meet face to face with an IRS auditor without a professional representing you. Tax laws are complex. A carefully planned audit strategy may save you much more in potential taxes, penalties and interest than the fees paid to handle the audit.
An income tax audit starts with a sample period where the auditor tests the books and records to determine if they match the source documents prepared by third parties, such as bank statements, canceled checks, wire advice documents, loan documents, vendor invoices and more. He also may request a reconciliation of amounts reported on sales tax or payroll tax returns to the amounts recorded on your books and reported on your income tax return. The sample period is usually a month or several months. If the auditor finds exceptions in the sample, such as unrecorded cash or improper expenses that are material, or gross revenue reported on sales tax returns that don’t match those reported on the books and records, he will expand the sample size to include several or all months covered by the return.
When an auditor finds exceptions, he also may audit all tax returns open under the statute of limitations. For IRS purposes, it’s three years, unless there is gross negligence or fraud, which can be several more years. If the audit expands, be prepared to have at least three years of returns examined. This is where professional tax representation is extremely important. The tax professional will create or organize all schedules and reconciliations showing that all revenue and expense items trace and agree to the tax return. If they don’t, the professional will document the reasons for departure. Based on the professional’s experience, he also will anticipate which items create tax exposure and come up with a plan to handle them.
In my experience with tax audits for landscape and lawn care professionals, most accounts will be tested, but an auditor will look at the following items in depth.
1. Revenue. The auditor will look for evidence that all your sales are properly recorded through sales records that trace and agree to your bank statements and reasons for any departures.
2. Employee compensation. Compensation must trace and agree to payroll records, including forms such as 941s, 940s, W-2s and W-3s that are filed either by yourself or by your payroll company.
3. Outside contractors’ expenses. If you use outside contractors, you will need to show invoices, checks issued, 1099s issued and proof that the subcontractors are truly subcontractors and not W-2 employees. The 1099 versus W-2 issue is subtle but extremely important. If, in the auditor’s opinion, the subcontractor is really an employee, you may be subject to employment taxes.
4. Professional fees. Again, an auditor will look for invoices, checks issued and 1099s issued for the same reason above—to prove that you did hire a professional rather than calling someone on your staff a professional and paying him without remitting payroll taxes.
5. Travel, meals and entertainment. Keep calendars, diaries, appointment books and logs to document any legitimate expenses. This is one of the most abused deductions and without such evidence, an auditor may disallow the entire deduction.
6. Office expenses. You should have receipts, canceled checks and credit card statements to substantiate office expenses. Auditors may look for large furniture and fixtures that were improperly expensed and should have been capitalized and depreciated over several years.
7. Other miscellaneous expenses. Often, this is a dumping account for expenditures that can’t be categorized easily. If you have a miscellaneous expense account, make sure the items in it are legitimate, deductible expenses.
The most important thing is to come prepared and be organized in category and chronology.
