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How to Handle a Tax Audit

Howard Scott |

PEMBROKE, Mass. — You open a letter from the IRS: You are being audited. A shock goes through your body. Your hands begin to shake. The timing couldn’t be worse. You’ve got a half-dozen projects going on. “Why me?” you ask. Then your mind pictures what it would be like to languish in jail.

Don’t panic. An audit doesn’t necessarily mean there is suspicion that you aren’t being forthright. A portion of all business audits are random selections. Furthermore, an audit doesn’t mean that you will have to pay a large bill. About 25% of audits result in dismissal. Satisfy the auditor and you probably won’t be bothered for many years.

Having said that, there could be cause for alarm. If you are deliberately inflating expenses or understating revenue figures, the auditor will seek to discover these untruths. Reducing revenue is considered fraud and could result in criminal prosecution. Overstating expenses is bad, but one could argue that the books were messed up, the bookkeeper was incompetent, that the computer system malfunctioned, or that you just didn’t understand what was required. In other words, it is easier to make a case for overstating expenses than for understating income.

The simplest audit is a correspondence audit. You are asked to clarify one or two issues. Responding with a letter that includes proof backing your position will end the inquiry. Office audits require meeting with an IRS auditor.

Most office audits specify areas of concern. Speak frankly to your accountant or CPA. Together, evaluate the magnitude of the audit. If it is over a few areas, and your books are in order, you might want to handle the matter yourself. If you prefer, your accountant can represent you. Of course, the accountant will want to be paid. Many preparers start their billing at $200 an hour, and that includes preparation time and representation. Any lawyer, accountant or enrolled agent can represent you, providing he/she did the taxes of that year’s return.

“I prefer to do all the talking,” says H&R Block’s Stuart Campbell, a longtime audit representative, “although I involve the client a bit to establish credibility.”

An audit is always conducted at the convenience of the person being audited. You decide whether you want to meet at the auditor’s office, at home, or at your place of business. It mostly depends on how methodical you are.

Organize your records. Make sure you can back up every figure on your tax return. That means making copies, updating logs, and putting everything in sequential order. If there is no backup, prepare a written explanation of the deduction. If the books aren’t in order, get them in order. This task involves a lot of work, but it will make you knowledgeable about your situation.

Do not go into the meeting acting like an angry bull. Remember, you’re dealing with a human being. But at the same time, do not be a fawning sycophant begging for mercy. Be professional and business-like.

Let the facts and figures do the talking. You’ll go over item by item. The auditor might say that an expense is disallowed. Do not argue. Go on with the proceedings.

Let’s consider a few examples. If you have no backup, come up with an explanation of why there is no documentation. For example, you had work done on your front counter, but do not have the receipt because the contractor disappeared after being paid. Suggest that you could try and track the contractor down. The auditor might go along since it is a reasonable expenditure.

If your cost of supplies is way above the regional average, say 15% of revenue vs. the average of 11%, come up with a plausible explanation. Your prices are extraordinary low, which brings up the percentage. You lost a lot of supplies in a basement flood, and you had to replace everything. You believe in high quality, and that pushes up your cost percentage. Formulate an argument that sounds plausible and is hard to reject.

If you purchased an at-home computer for $1,400 that you say is for business use only but the auditor argues that computer use can’t be limited to business only and will only give you a $700 Section 179 deduction (50% of cost), don’t argue. Let the $700 go. He’s being a stickler. Don’t fight the small potatoes.

Don’t try to outsmart the auditor. Come clean with all major discrepancies up front, especially revenue figures. Most likely, the auditor has the proof in the form of bank statements. Also, don’t ignore IRS letters. One operator who let the letters go resulted in the IRS assessing him $135,000 based on what they figured for his obligation. Divorce, bankruptcy and home foreclosure followed.

At the end of the session, the auditor will add up the adjustments and disallowances and come up with an assessment. Any penalties and interest, which could be hefty if being audited from two or three years back, will be tacked on. It is possible to counteroffer, which is called an offer in compromise. The auditor will be more inclined to go along if you are close to insolvent. But you never know when he or she will be willing to bend. It also helps your position if you can pay off the liability right away. If you can’t, you can arrange a payment schedule over time.

You may challenge the assessment, dealing with an appeals officer, and then you may go to tax court. If there are legal points at stake, you might hire a tax attorney, who might find precedents that could sway the judge. On the other hand, it might be less stressful to swallow hard, pay the bill, and make sure you keep detailed books in the future.

About the author

Howard Scott

H&R Block

Industry Writer, Drycleaning Consultant, and H&R Block Tax Preparer

Howard Scott is a longtime industry writer and drycleaning consultant, and an H&R Block tax preparer specializing in small businesses. He welcomes questions and comments, and can be reached by writing Howard Scott, Dancing Hill, Pembroke, MA 02359.

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