How to Prepare for a Business Tax Audit

When You Receive an IRS Audit Notice

Preparing for a Business Tax Audit
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Preparing for a Tax Audit

The best way to prepare for a tax audit is not to be audited at all. But everyone is human and mistakes are made. Trying to be as accurate and complete in your business income tax returns is important to avoid an audit.

Types of IRS Audits

The IRS carries out three different types of tax audits:

  • Correspondence audits, by letter. In this type of audit, the IRS is asking for verification or error correction or additional documentation.
  • Office audits, in which the taxpayer is requested to come to an IRS office and to bring specific documents.
  • Field Audit in which the IRS comes to your place of business. This type of audit is more comprehensive, and the IRS can request any forms, documents, or previous years' tax returns within certain limits.

Limits on Audits and Collections 

The IRS can audit any business or personal tax return with three years of filing; it can collect back taxes owed for up to 10 years. So, if a 2018 audit of a return filed in 2015 finds discrepancies in a return or returns filed between 2008 and 2018, it can collect taxes on all those returns.

Exceptions to the limits on audits and collections can be made by the IRS for tax evasion, filing a false return, or filing no return, in addition to other exceptions. (IRC Section 6501)

Tips for Preparing for a Tax Audit of Your Business

Let's say you have received an audit notification from the IRS or from your state.

When you receive an audit request, first contact your tax preparer or tax advisor before you respond. Even a simple IRS letter requesting a document might be a signal of a potential problem. It's always best to review the request with someone who can help you craft a response. Yes, this will mean additional money for the services of a CPA or tax attorney, but it could save you more issues later. Read more about who can represent your business before the IRS.

Get your records in order. IRS auditors can impose penalties on your business for poor records. Organize records by year and by type (income, expenses, pension plans, etc.). Make sure all relevant records are available. If they aren't getting busy acquiring them. Request bank or credit card records or information from vendors. If records aren't available, don't make them up!

Make every effort to reconstruct lost or destroyed records, and document your efforts. If there was a fire in your office, for example, document your attempts to reconstruct your business records, and show that you did backups of records.

Understand intentional vs. unintentional failures. Intentionally minimizing your business taxes by illegal means is tax evasion, and it's against the law. If you can show that your issue (no records for a particular year, for example) was unintentional, the IRS tends to be more lenient. On the other hand, they are much quicker to impose fines and penalties for intentional actions or omissions.

Make sure you don't have any personal expenses in your business records. You must keep personal and business expenses separate, with different bank accounts and credit cards and separation of business and personal travel expenses. Read more about separating business and personal expenses for tax purposes.

If you are being audited for having multiple years of business losses, you will need to show that you were working hard to make a profit and be a real business and not just a hobby. Selling and marketing expenses, keeping excellent records, will help you make your case.

Issues of Focus for IRS Audits

The IRS looks more closely at certain kinds of businesses and business activity. For example: 

  • Cash businesses, in which it's easy to under-report income. Cash businesses are more likely to be audited and it's difficult to prove income for a cash business.
  • Be prepared to show documentation of (1) business travel and (2) business entertainment and meals. These expenses are top targets for the IRS, and you must show the business purpose for each expense. The records must be contemporaneous (at the time) and include date, time, amount, who was there (if appropriate) and specific business purpose.

Home Business Tax Audits - A Different Case

Home-based businesses must do a little more to prepare for a tax audit. Audits of home businesses typically focus on the business's attempt to deduct expenses for the use of the home business space. It's one of those audit "red flags" you may have heard about.

The auditor wants to make sure that the room or part of a room that is being used for business is used both regularly and exclusively for that purpose. Preparing for a home business tax audit means making sure your office space is clear of anything personal - and yes, that includes your computer. Here are some other tips for preparing your home space for a business tax audit.

Disclaimer: The information in this article isn't intended to be tax or legal advice. Every business situation is different and tax laws and regulations change often. Before you begin preparing for a tax audit, get help from a tax professional who is qualifiedto represent you before the IRS.