As an attorney that assists clients with audits, I see simple mistakes turn into huge problems. If you own a small business, you must follow record-keeping rules and if for no reason at all it is to save on attorney fees during an audit. I receive numerous questions in connection with an audit, including the procedure and timing of which.
Everyone is at risk for an audit, but especially high net worth individuals. Often individuals with small-businesses that are performing well run into problems as a result of inadequate bookkeeping. As a result of the end of COVID-19, the IRS has repeatedly announced their increase on tax examinations.
The IRS Audit Selection Process
The IRS selects a tax return for examination through several different methods. The main method is that the IRS uses computer programs to compare tax returns with statistical “norms” in the industry to identify outliers. This is a very targeted approach towards small businesses and self-employed. The computer programs screen for under-reported income, excessive deductions, such as the home office and mileage deductions, and large travel, meal, or entertainment expenses. The IRS also gets notifications from the banks on any transaction greater than the $10,000 to the IRS.
Further, each year the IRS publishes a “Dirty Dozen list”. Transactions on this list are known as having consistent fraudulent behaviors and the IRS pays attention to tax returns with any items that are on the list. Currently, the Employee Retention Credit (“ERC”) is at the top of the list. The IRS plans to audit the majority of businesses that filed claims to receive the ERC because there have been promoters throughout the country that have been conning ineligible people to claim the credit.
Another large target is the reporting of cryptocurrency. The fuel tax credit is meant for off-highway business and farming use, and as such, is not available to most taxpayers; however, many taxpayers erroneously claim the credit. Over the past five years, the IRS has also consistently targeted conservation easements. Further, the IRS began cracking down on non-payment of federal income tax owed in relation to cryptocurrency transactions in 2019. Similar to cannabis and cryptocurrency, the rise in the popularity of online gambling, has led to an increase in IRS scrutiny of gambling proceeds.
Lastly, another main avenue in which audits originate is whistleblower reports or referrals. Often a disgruntled employee will report suspected tax fraud activity, especially because the IRS and most states offer rewards for reports of taxpayer fraud.
Although, the odds are in your favor if you are a small business you should always try to be compliant because many little things could spark an audit. .
The General Process Of An Audit
Most taxpayers don’t understand the full force of the IRS. First, the IRS will generally send notices and introduce the revenue agent. The Revenue Agent then sends an Information Document Request (IDR) to request list of documentation. The IRS has a list of documents they commonly request, which includes receipts, insurance reports, medical records, logs or diaries, tickets, and other documents pertaining to the tax deductions claimed.
Next, an audit entails an interview with the taxpayer, typically this will take place with the managing shareholder or partner of the business. This interview allows the IRS to understand the premise of the business and any follow up questions in relation to the first IDR. Before this interview it is important to prep, which includes reviewing the prior responses to the IDRs, including the documentation provided previously. Revenue Agents generally want to view all books and records for the past three tax years.
After the interview the Revenue Agent may send follow-up IDRs or perform a field visit. A field visit is one in which the revenue agent tours the business and possibly communicates with the employees. In this visit they want to ensure that your business is in fact engaged in the activities you described in your interview.
Once a Revenue Agent concludes its investigative process, they will issue a report and hold a closing conference. In the event that you do not agree with the report, you can ask to speak to their manager, go to IRS Appeals, or even file a petition with the USTC
Items To Remember
I always caution people to contact an attorney immediately after you receive notice from the IRS. It is extremely important to have the attorney handle all communications and to be present during the initial interview. First, an attorney knows why a Revenue Agent is asking specific questions. Second, it can quelch tensions.
Audits are evasive – they ask detailed questions regarding the business for the past three years. The interview may either be in person or over the phone depending on the revenue agent. Revenue Agents are there to ensure that individuals are not taking advantage of the system. As a result, they act and are investigators, looking to trace every penny your business, and possibly yourself, received over the past three years.
If the Revenue Agent senses for any reason at all that you are being untruthful, they will expand the examination to include not only the prior three years of the business, but also all other businesses you have an ownership interest in, as well as your personal income taxes. Additionally, if they believe that you are not responding honestly and providing all documents, under Section 7602, the IRS has the authority to contact third parties. They must send notice before engaging in this activity, but it is a possibility.
As a result, it is important to always keep accurate and clear records of your books. If you are able to easily provide documentation of everything, the process will be fairly simple and straightforward. Meanwhile, if things are not clear, you could spend more on attorney fees than what you owe in taxes.