From the May 1999 issue of Entrepreneur

It's no exaggeration to say that most entrepreneurs would prefer a root canal to an IRS audit. The thought of IRS scrutiny terrifies even the bravest of souls. But if your return is selected as part of this year's audit process, don't despair.

For one thing, taxpayers now have more rights than ever when it comes to dealing with the IRS. Under the IRS Restructuring and Reform Act of 1998, the tax agency has been encouraged to speed up the audit process. If it doesn't provide notice of an audit to the taxpayer within 18 months after a return is filed, interest and certain penalties will be suspended. Beginning in tax year 2004, the IRS will have to provide that notice within 12 months.

The law also restricts the use of "lifestyle" audits. When performing this type of audit, the IRS used to ask for extensive information about the taxpayer's financial status, standard of living, and other information not directly related to the tax return. Now it can request this information only if it has a reasonable indication, based on the tax return itself or third-party information, that the taxpayer has unreported income.

Another plus for entrepreneurs: The collection processes used by the IRS have greater limitations. The IRS must now follow the same rules as private debt collectors when communicating with debtors, such as not being able to contact individuals before 8 a.m., after 9 p.m. or at their places of employment.

If you are selected for an audit, having these protections in place makes it possible to get through the process with relatively few nicks and bruises, say tax experts. Just be prepared, have the right attitude and show them your flawless records.


Joan Szabo is a writer in Great Falls, Virginia, who has reported on tax issues for more than 13 years.

Your place or mine?

Generally, business returns are selected for either an office audit or a field audit. An office audit takes place at an IRS office and generally covers several specific issues on a return, though it can be broader in scope. When more complex items are in question, a field audit is held at your place of business. Field audits are more extensive and take more time to complete than office audits.

While the IRS doesn't publicize its criteria for requesting an audit, experience indicates certain types of tax practices set off red flags. For example, if your business expenses are especially large in relation to income, or if you report complex investment or business dealings without adequate explanation, your chances of being audited increase. Another big red flag for small businesses: independent contractors. If you use contractors, be sure you have the necessary documentation to support this classification, or you could soon find yourself up to your nose in employment back taxes.

As you may know, the IRS is putting together specialized profiles of small businesses to help agents flag potential problems in returns and boost tax compliance. Called the Market Segment Specialization Program (MSSP), the guides are designed to help agents when they review returns filed by businesses in specific industries. Over the past six years, the IRS has compiled MSSPs for more than 40 types of businesses and professions, including construction, commercial printing and food vending. Another 70 MSSP guides are expected to be prepared in the near future. If your industry or profession is covered by an MSSP guide, it's a good idea to review it. The guides can help you organize your company's tax affairs so you can avoid an audit or come through one with as little difficulty as possible. Many of the guides are available at http://www.irs.ustreas.gov/plain/bus_infor/mssp/index.html They can also be ordered for a charge from the Government Printing Office at http://www.access.gpo.gov/su_docs or by calling (202)512-1800.

The IRS Comes Calling

If the IRS selects your business to be audited, the best strategy is to cooperate--as quickly and efficiently as possible. "You don't want to be contentious. You want to appear cooperative and demonstrate that you're helping make the agent's job easier,' says Paul Thrasher, a CPA with the Alexandria, Virginia, accounting firm Halt, Thrasher & Buzas. Here are some other important steps to follow:

  • Hire a stand-in. Tax experts say it's best if you don't try to represent yourself. "[The IRS] doesn't care whether the client appears. All the tax agency cares about is the documentation,' Thrasher says. You can authorize an attorney, CPA or enrolled agent to represent you at the examination. Keep in mind that whomever you designate will need power of attorney to represent you.

Hiring an experienced tax professional to represent you can also help keep the audit contained to the specific tax areas at hand and expedite the process. If the IRS agent wants a meeting with you, "Make sure the accountant is sitting there and leading the conversation,' Thrasher says.

  • Give yourself enough time to prepare. The IRS may try to pressure you into an early audit date, or an agent may even appear at your home or office and try to start the examination immediately. Don't let that happen. Tell them you need time to see your accountant and prepare. Set a date that gives you the time you need. That way, your accountant or attorney will have sufficient time to review your return and make sure you have the necessary receipts.
  • Don't volunteer information. If you decide to go it alone, answer only the questions asked. "It's possible to get yourself into trouble with idle chatter,' says Jan Zobel an enrolled agent in Oakland, California, and author of Minding Her Own Business: The Self-Employed Woman's Guide to Taxes and Recordkeeping. And provide only records that directly relate to the items questioned in your IRS notice to avoid opening yourself up to other areas of investigation.
  • Give them their space. If your business is selected for a field audit, be sure to give the IRS agent a work area that's set apart from employees, recommends accountant George Rohe with PricewaterhouseCoopers LLP in Charlotte, North Carolina. Select a "point person" in your business to deal with the auditor, advises Rohe. This person should provide the necessary records, make copies and be a general contact for the auditor. After all, your accountant doesn't have time to hang around your business for days while the audit is being performed.

The Aftermath

If you maintain scrupulous records and can produce all relevant receipts and documents, your chances of prevailing are much better than if you fail to do so. And keep in mind that if you disagree with the outcome of the audit and believe you have sufficient evidence to prove your point, you can appeal the matter. There are several layers of appeals, including an appellate conference with the IRS, the IRS Appeals Office, and the U.S. Tax Court. Your tax professional can offer the best advice on how to proceed.

If you're prepared, tax audits don't have to cause pain. Following the steps outlined here should help you get through the experience intact.

Singled Out

As a group, small-business owners are audited more frequently than average taxpayers, says small-business analyst Susan Jacksack of CCH Inc., a provider of tax and business law information in Riverwoods, Illinois.

IRS statistics show the tax agency audited between 2.57 and 4.13 percent (depending on income level) of self-employed individuals filing schedule C forms in 1997. For taxpayers filing 1040 and 1040A returns, 1.21 percent to 2.27 percent were audited.

What's more, the higher the total gross receipts of a business filing a Schedule C return, the greater the possibility that an audit will be performed. According to the IRS, Schedule C filers with total gross receipts of more than $25,000 but less than $100,000 had an audit rate of 2.57 percent. That number jumps, however, to 4.13 percent for those with more than $100,000 in total gross receipts.

Next Step

  • The IRS has published a new edition of its free Publication 1, "Your Rights as a Taxpayer." It includes some information about the general criteria the IRS uses to select taxpayers for audits. To obtain a copy, download it from the IRS Web site at http://www.irs.ustreas.gov</> or call (800)829-3676.

Contact Sources

CCH Inc., (800) 248-3248, http://www.toolkit.cch.com

Halt, Thrasher & Buzas, 99 Canal Center Plaza, Alexandria, VA 22314, (703) 836-1350