Preparation and organization are critical if the IRS decides to audit your business. You may want to consult a tax professional who can help you gather the necessary materials and advise you on how to present your position to the auditor. If a tax preparer handled your return on your behalf, you should contact them so that they can explain their calculations. By carefully organizing your materials before presenting them to the IRS, you may get the benefit of the doubt from the auditor in any areas that seem questionable. The auditor also likely will be impressed if you know enough about the tax law to explain how you determined your tax obligation and why you claimed certain tax benefits. Conversely, the absence of essential documents or a murky explanation for your calculations may cause the auditor to draw negative inferences.
You will need to provide several types of documents to the auditor. While they are free to accept an oral explanation for your decisions, it usually helps to present tangible support. This may include bank statements, electronic records, business records and ledgers, invoices, receipts, canceled checks, and any other logs or business diaries that document the activities and expenses of the business. If you used certain types of property for both personal and business purposes, you must supply the auditor with records of the portion of use that was related to your business. A common example involves a car that you drive for personal errands as well as business trips. You also must provide detailed records of business travel costs and meals related to your business. (Read more here about the specific record keeping requirements for business meals.) If you bought or rented property for your business, you should show the auditor a copy of the purchase contract or lease.
Common Concerns for Auditors
One of the main issues that an auditor will consider is whether a business owner has classified workers as independent contractors rather than employees. Many businesses misclassify workers to avoid paying employment taxes and providing those workers with benefits, but misclassification can result in severe penalties. (Read more here about the difference between employees and independent contractors.) Similarly, the auditor will want to make sure that you are keeping up with any employment taxes and tax returns that are required.
An auditor also will want to make sure that you did not inappropriately claim deductions for business expenses that were actually personal expenses. Unless the value is very minor, you can expect the auditor to wipe out these deductions and possibly impose penalties. They may examine deductions especially closely if they relate to business meals, business trips, and the use of a vehicle for business purposes. If you have only one car, for example, you cannot plausibly claim that you use it only for your business.
In general, an auditor will observe your overall lifestyle and use their common sense to judge whether it corresponds to your tax return. If you are reporting an income that seems inadequate to support your lifestyle, you can expect the auditor to look more closely at your situation. They also may take a closer look if large amounts of cash pass through your business, since this creates an opportunity for a business owner to retain unreported income. If you have dramatically underreported your income, you may face a criminal investigation and severe penalties. You may want to get a tax attorney or another tax professional involved to limit the consequences to the extent possible.