Audits

So You're Being Audited. Now What?

This story appears in the September 2014 issue of Entrepreneur. Subscribe »

Lucky me. I came home from vacation last spring to find a letter from the IRS alerting me that they were auditing my 2011 tax return--specifically, my Schedule C (profit or loss from business).

No problem! I thought. I'm honest and organized.

Ha! Although my intentions are honorable, I do make mistakes. And it turns out my organizational system--dumping all my tax documents from the past decade into a big box--left much to be desired.

Fortunately for you, my nightmare is your gain, as I learned a slew of valuable lessons during the audit. I contacted my accountant and had him outline some goals. First was to minimize my financial liability for the year under investigation by convincing the auditor that I'd reported all income and that all of my expenses were justified. Complete records would be my best defense against additional taxes and penalties (although I found out I needed to do a better job of organizing them).

Related Book: What Your CPA Isn't Telling You

Additionally, I wanted to prevent the investigation from expanding beyond the year in question. In my case, if the auditor suspected serious problems with my 2011 return, she could also look at 2010 and 2012.

Here's what else I picked up during the three-month ordeal:

  • Get help. Immediately hire a tax professional, even a tax attorney, to represent you. A pro will have a much better understanding of tax law and the audit process and can coach you on what to say and do. The $1,650 I spent on mine was a bargain compared to the thousands the IRS was claiming I owed.
     
  • Don't volunteer information. Be honest and forthcoming, but answer only what you're asked. Don't provide any more documentation than requested, as each additional piece of information is another chance to uncover errors.
     
  • Don't file a tax return during an audit. If you do, the audit could expand to include the new information. I received notice of the audit in late March, just before I was due to file my 2013 return. My accountant applied for an extension immediately.
     
  • Get organized. As soon as you receive the audit notice, start gathering the requested information. This process will take longer than you think, especially if you're like me and discover that some pieces are missing. It can take weeks to receive duplicate statements from your bank or broker.
     
  • Get it on paper. The IRS doesn't deal with electronic files during an audit; only a paper trail will do. I learned the hard way that many financial institutions keep statements available online for download only for a few months. Now I print out all my statements as soon as they become available.
     
  • Be courteous. You may hate the IRS and resent the audit, but don't take it out on the auditor. Be polite and professional. Imagine that you're at a job interview, and act accordingly.
     
  • Change your habits. It's easier to get organized now than to create a new system under duress, like I did. After my audit, I adopted an embarrassingly simple step: I labeled a file folder "2014 taxes," and I've been placing all the year's financial documents there.

A Fighting Chance

I found the IRS website to be surprisingly helpful, specifically the 10-lesson video series "Your Guide to an IRS Audit," which provides basic information about the small-business audit process.

Another great source for tips is Stand Up to the IRS by tax attorney Frederick W. Daily. The entire text of the book, in print since 1992 and updated in 2012, can be found at TaxAttorneyDaily.com.