The very word "audit" can strike fear into the heart of any business owner. No one enjoys having the IRS search through their financial records with a fine-tooth comb — and that's especially true if company leadership never prepares for an audit in the first place.
The good news is that, in most cases, you can adequately prepare for an IRS tax audit and come out the other side with your business and personal net worth intact. The key is to understand the audit process's basics and have all the required documentation on hand and ready for inspection.
Let's discuss what happens during an audit, what factors may trigger one, and what you should expect from the overall process. Armed with this knowledge, your audit preparation can be a smooth and (mostly) stress-free activity — especially if you outsource your tax services to a reputable third-party agency.
Let’s get down to it!
What Exactly Happens During a Tax Audit?
No two audits are indeed alike. The audit's precise nature will depend on several variables, such as your business type and how closely the IRS wants to scrutinize your records. Nevertheless, all IRS audits generally follow the same basic process.
Understanding the Steps of the Audit Process
Below is a step-by-step scenario of a traditional audit process. This will help you better understand what will happen so you are not caught off guard.
1. The IRS Contacts You
The IRS may conduct an audit in several ways (which we'll discuss more fully in one of the following sections). However, the IRS will always contact you initially by mail. In the audit letter you receive, they will provide all relevant contact information and instructions for you to move forward with the audit process.
The letter may request additional information about items shown on your tax return, such as:
- Income
- Expenses
- Deductions
- Claimed credits
If you have too many books or records to reasonably send via mail, you can request the IRS to perform an in-person audit of your business. You’ll receive the instructions for that in the initial letter.
2. You Provide the Documents Requested By the IRS
The IRS will provide you with a written request for all the specific tax documents and records they would like to see. The IRS may accept electronic records produced by tax software in place of or in addition to hard copy records.
If you need more time to prepare all the necessary documentation, you can either fax or mail an extension request to the IRS per the instructions found in your audit letter. (For in-person audits, you can contact your assigned auditor or the appointed auditor's manager via their individual contact information.) The IRS is typically willing to grant one automatic extension of 30 days; however, the agency will contact you if it cannot honor your extension request for any reason.
3. The IRS Processes Your Documentation
If you're sending your tax documents to the IRS via mail, using Certified Mail or some other delivery confirmation service is a good idea. Once the IRS receives your documentation (or an auditor begins their face-to-face audit), they'll need time to evaluate and process your records.
In most cases, the IRS will include returns filed within the last two or three years in their audit. Keep in mind that if they find significant errors, the IRS has the prerogative to add additional tax years to their evaluation.
An audit may take three to six months to complete, depending upon the complexity of your returns, the availability of information requested, and whether you agree or disagree with the auditor's findings. Very complex audits may even take a year to resolve.
4. The IRS Concludes Your Audit
The IRS can conclude an audit in one of three ways:
- No change. This is usually the best-case scenario for a business owner. The IRS finds that you have substantiated all items under review and determines that no changes to your returns are necessary.
- Change—agreed. In this scenario, the IRS proposes changes to your returns; you understand and approve. You'll sign an examination report from the auditor to verify your agreement. If you owe additional tax, you'll likely be able to work out a mutually acceptable payment schedule (if a single lump-sum payment isn't feasible for you).
- Change—disagreed. Finally, the IRS may propose changes to your returns. Even if you understand those changes, you may disagree with them. In that event, you can request to meet with an IRS manager, ask for mediation, or file an appeal with the U.S. Tax Court (assuming there is enough time remaining on the statute of limitations).
It's important to note that any difference you need to pay off has accumulated and will accumulate interest at a rate of 5% per year, starting from the date of your original return, compounded daily. You could face a penalty of up to 25% of the tax deficiency for very serious errors. Of course, the punishment could include prison time where fraud is involved.
Audit Preparation: IRS Audit Triggers
According to one estimate, the odds of the IRS ever auditing your business is about 1 in 333; not very likely. Nevertheless, certain "red flags" on tax returns may trigger an audit for your business. These may include:
- Using round numbers
- Neglecting to report corporate employee salaries
- Taking high meal and entertainment or home office deductions
- Claiming a vehicle was used 100% for business
- Not making quarterly tax payments
- Claiming business losses several years in a row
- Missing tax deadlines (filing the return late)
- Reporting higher-than-average income
In addition, the IRS tends to primarily focus on certain types of businesses and activities, such as businesses that frequently receive cash as revenue (since it's much easier to underreport cash earnings compared to check or direct deposit income) and that deduct a high volume of travel, meal, and entertainment expenses.
Granted, none of these factors mean that an IRS audit is inevitable. However, one or more of these items on your tax return may greatly increase the likelihood of receiving that audit letter in the mail.
What to Expect If Your Business Is Audited
What should you expect from the process if your business falls into that small category of companies that get audited? First of all, it's important to know that the IRS conducts three basic types of audits:
- Correspondence
- Office
- Field
The least common type in the list above is the office audit, in which the taxpayer needs to deliver specific documents to the nearest IRS office. Instead, a correspondence audit (or mail audit) is the most likely scenario for your business.
One study we mentioned earlier found that almost three-fourths (74%) of IRS audits are by letter. An error sometimes triggers correspondence audits, and the IRS may specifically ask you to correct it during the audit. Mail audits are generally limited to the items mentioned in the audit letter.
In contrast, field audits are the most in-depth and often involve a comprehensive examination of a company's financial records and accounting systems. For a field audit, you'll need to thoroughly prepare your tax documentation and be ready to answer in-depth questions about your finances and business activities. For this and other reasons, it may be wise to have a licensed tax professional represent you and advocate for your tax position before the IRS.
IRS auditors must follow certain guidelines and procedures to examine your company's financial records. The IRS publishes a list of Audit Technique Guides for public consumption. You can read the corresponding guide for more information if you'd like to know what to expect for your specific business.
Tax Audit Expiration Limits
Finally, it's important to realize that the IRS can only go back so far in the past to audit you and they have limits on how much they can collect. In most cases, the IRS can only audit business tax returns within three years of filing.
However, the agency can collect any back taxes owed for up to 10 years. In other words, if they discover a discrepancy in a return, they can examine others and collect owed taxes up to 10 years before the original return.
Protect Yourself in Case of an Audit
In summary, the IRS is unlikely to audit you. However, it's not impossible; if it happens, audit preparation is crucial. Understanding how the process works and your rights can help lower stress and save you precious time and money.
Of course, the best thing you can do to protect yourself in the event of an audit is to have an experienced tax professional who can help you thoroughly prepare for the IRS examination. At Hiline, our outsourced tax services are second to none—and we're available year-round to assist with any and all of your tax needs, including an unexpected IRS audit.
Reach out to us today to learn more about how we can help.
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