It’s something Businesses try to avoid (at all costs!), but sooner or later somebody pulls the unlucky proverbial straw and is selected for an IRS audit.  Your records may be impeccable, but the auditor is still sitting across the table with a “guilty until proven innocent” look on their face (or, at least, that’s your perception!).

So what might an auditor be looking for?  Be aware that not only will the IRS be looking at your books and supporting records, they will also be looking at YOU and assessing whether or not you match up to the income reported on your return.

According to Frederick W. Daily, tax attorney and author of Stand Up To the IRS, the IRS will most likely look into the following if your business is audited:

Can the income reported on your return support your current lifestyle?

If available, the auditor will look at your clothes, jewelry, car, home, furnishings to see if you are living in the lap of luxury while your income tax returns look more like you should be living in a cardboard box.  If there is a discrepancy, be prepared to offer up an explanation.

Does a lot of cash flow through your business?

If so, an auditor may suspect skimming right out of the gate.

Did you write off auto expenses for your only car?

Using a business vehicle for personal use is quite common and an auditor will most likely expect to find it.  However, taking an unreasonably high percentage of business deduction for your only car will probably end in an adjustment to your return by the IRS. 

It’s best to keep adequate records such as a mileage log to prove the deduction taken.  As a suggestion, keep either a monthly calendar in your car or use the calendar on your PDA to track mileage and business purpose.  This will be a win-win solution as your records will be detailed enough to support the deduction AND it will be easy to calculate with your mileage deduction come tax time.

Did you claim personal entertainment, meals or vacation costs as business expenses?

This is another area to expect the IRS to spend a fair amount of time examining the validity of the deductions claimed.  They will want to find out if you are trying to write off dinners with friends, vacations with the family, etc.  Again, keep detailed, accurate records. 

At a minimum, you should be prepared to produce the receipt and documentation supporting who was at the function, the business purpose, their relationship to your business and what was discussed (this is all documented in the IRS Publication 463 relating to Travel, Entertainment, Gift and Car Expenses).  I recommend that you log this on the back of the receipt at the end of the meal and then place that receipt in a dedicated file and/or envelope which can be pulled out when preparing the tax return.  This way, all of the required information is there and you don’t have to recreate anything if asked for backup by the IRS.

Did you “forget” to report all of your business sales or receipts?

If you failed to report $10,000 or more of your business income and it looks intentional to the auditor, the IRS may call in their criminal investigations team. 

Are you filing your payroll tax returns and making tax payments for your employees?

This is a routine part of every audit so be prepared to supply the returns to the auditor.

Are your independent contractors really employees?

It’s easier (and cheaper) to pay people who do work for you as independent contractors but be very careful.  There are strict guidelines as to who qualifies as an independent contractor and who is really an employee. 

Among many other things, the IRS will look at the following to provide evidence of the degree and control of independence:

• Behavioral – Does the Company control or have the right to control what the worker does and how the worker does his or her job?
• Financial – Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
• Type of Relationship – Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

 If you do have independent contractors working for your business, you will want to ensure that you are collecting W-9s from them (Request for Taxpayer Identification Number and Certification) and filing any applicable 1099 at year end for monies paid.

 Hopefully, this has helped to give you a little more insight to what auditors look for and the best way to be proactive in providing the information to them (or, at least, help you and your CPA in your recordkeeping).  If you have any questions about anything listed above or are in need of a CPA, please feel free to give me a call. 

About the author: Shannon Pope is a CPA serving North Houston from The Woodlands, TX to Kingwood, TX.  For more information on her background and services offered, please visit the website www.shannonpopecpa.com.

The information contained herein is general in nature and provided for informational purposes only.  It is not intended or provided to constitute tax or legal advice or to be used for (a) avoiding any tax related penalties that may be imposed on you or any other person/entity under the Internal Revenue Code, or (b). promoting, marketing or recommending to another person any transaction or matter addressed in this communication. Please consult with your CPA and/or attorney regarding your specific legal or tax situation. Please contact us if you with to have formal written advice on this or any other matter.