According to H&RBlock, the average amount owed after an office or field audit (will be explained later) is $65,000. With so much money to possibly lose, it’s important you understand audits and how to handle them.
What is an audit? Why was my business chosen?
An audit, in simple terms, is a thorough examination of the financial statements of a business. When most people think of audits, they are thinking about the IRS. While the IRS does audit people, you can also be audited by others; like your state government or another private company. One of the most common reasons for private audits is because someone inside the business wants to ensure their business’s financials are accurate. By doing this, it can guarantee the company’s credibility to investors, stakeholders, etc. In the intro above, we specified office and field audits. There are a slew of different types of audits but the IRS has three that it uses; these are: correspondence (may also be referred to as mail), office and field. In a mail audit, the IRS is typically looking for verification of something specific and will need proof that they request back in the mail. An office audit sends out a request to review in person (their office) and requires you to bring along all needed documents for the reason it lists. And lastly, a field audit sends a representative to your place of business who examines every single part of your tax return(s). These audits get more serious and comprehensive as you go from mail to field.
Being audited by the IRS does not necessarily mean you have done anything wrong. There are a multitude of reasons that can trigger red flags to the IRS. One of the number one reasons that set off an audit is deductions. As a business owner, you can get deductions on your tax returns for expenses (based on your type of business). Having too many deductions may set off an audit, even if you are doing everything correctly. Another common reason that triggers an audit is too high or too low of a pay for others, or even yourself. As an example from RCReports, “Too-low salaries are often intended to avoid payroll taxes…..An S-Corp owner who pays herself only enough to contribute the maximum amount to a traditional 401(k) (tax-free) could be subject to back taxes, fees, and penalties unless she can prove her compensation was ‘reasonable.’” Next, having contractors, and mislabeling contractors vs employees, is another common reason you may be audited. (Here is a guide from the IRS to decide whether to count an individual as an employee or a contractor.)
Unfortunately, and annoyingly so, if you have been audited before, you are more likely to be audited again; especially if you owed money before. Auditors may excuse this as “seeing you learned from your mistakes,” or “checking that everything is going right now.” If they were able to get money from you beforehand, it makes sense they would try again (and again) and thus this is why you may be more likely to have repeat audits.
How to handle an audit?
The best way to handle an audit is to already be prepared. It’s crucial to keep records and documents of all business related financials. Furthermore, it’s in your best interest to keep your business and personal finances separate. It becomes significantly harder and more confusing to separate finances when you are using the same account for everything. Additionally, accountants (and CPAs) can be vital assets to your business. They can help review and record documents, keep you up to date with trends in your finance, and help make sure your finances stay accurate. (Check out some of our other monthly blogs to learn more about: the differences between CPAs and accountants, benefits of having a CPA, and how to find the right accountant for you!) Audits usually happen years back, so it’s important that you keep your records and they maintain accuracy!
So you’ve just been dinged for your first IRS audit – where do you go from here? In the beginning, you will always be notified by mail that you are getting audited – the IRS will NEVER call you. At this point, it is most advantageous to hire a tax professional if you do not have one already. CPAs often work well for this; but you can also hire a EA, Enrolled Agent, as they are a tax specialist that specifically represents clients to the IRS. The steps should be outlined and direct to follow after, but you can always call the IRS if you have any questions. Also, be honest! Making up numbers may cost you more and can cause the IRS to dig a lot deeper. For more resources around IRS audits, check out this page from the IRS.
Knowledge is Power!
Being informed and prepared for any audit that comes your way can make you stress less and keep your business safe!
