Scared by the prospect of an audit? This tax expert breaks down the various types of audits and the factors that may put you at risk.
MARCH 16, 2015
The prospect of an audit is one of the most dreaded experiences any business owner may face. Audits can be a considerable time drain on owners and staff, cost a lot in professional fees, and result in owing additional taxes, penalties and interest. Fortunately, the risk of being audited is low, and even if selected, the type of audit may not be as onerous as feared.
Types of Audits
Audits can take various forms, from minor inquiries by mail to line-by-line examinations at IRS offices or in your place of business. Identify the type of audit you’re facing by the correspondence you receive from the IRS:
Letter with notation of CP-2000. This isn't really an audit but merely a question about an item that IRS computers can’t square with what you have on your return (e.g., an omission of income that has been reported to the IRS on Form 1099-MISC or income that has been reported but doesn’t agree with amounts the IRS has for you). The letter tells you the IRS has made an automatic adjustment to your return reflecting the information it has in its computers and makes a demand for payment for the omitted income. You can pay up if you agree, or explain or contest the amount (you can do this by telephone or in writing, and usually don’t need a tax pro to help you). But if you fail to respond, your situation may devolve into an extensive examination.
Letter with notation of Form 566(CG). This is the classic correspondence audit, the most popular method used by the IRS to question specific deductions on your return. The IRS is merely seeking proof to support the positions you’ve taken on the return. Supplying the requested documentation (e.g., a canceled check, invoice, credit card statement) usually closes the matter. Again, you may be able to handle this yourself without a tax pro’s assistance.
Letter with notation of Form 3572 for audit at IRS office. This indicates a regular audit (office audit) for self-employed individuals and small businesses at the IRS where you and/or your representative must appear at a designated office at a designated time to review specific items on your return. Appointments can be rescheduled, but at some time the audit will happen. It’s highly advisable to have a tax pro there to make sure that the examination is limited to the initial items raised and that you don’t say anything which could expand IRS inquiry.
Letter with notation of Form 3572 for field audit. IRS auditors come into your place of business or even your home to look at things related to your return (field audit). For example, if you claimed a write-off for a particular machine, the auditor may want to have a look at it. The audit may not necessarily be limited to specific items; the auditor has leeway to question anything and everything on your return. Needless to say, representation by a tax pro is essential in this situation.
From time to time, the IRS also conducts extensive audits under the National Research Program (NRP), for which taxpayers are selected at random. In these audits, the IRS goes line by line, questioning everything on the return for one to three years. The audits are designed to elicit statistics that the IRS will use to better select future returns for audit, but those selected for the NRP audit can wind up owing taxes, interest and penalties. In the past several years, the IRS has conducted these audits for S corporation returns and employment taxes. Because there is a random selection, there’s nothing you can do to prevent one.
Note: The IRS may contact you by telephone for an audit but will always send a letter confirming the audit. The IRS never initiates contact by email.
Overall, the number of returns selected annually for audit is very small as a percentage of the total number of returns filed. For example, in 2014 the IRS audited only 0.86 percent of individuals, the lowest rate in a decade, and fiscal constraints mean the number of audits is not likely to increase any time soon. Of course, that number is small comfort to you if you’re one of the unfortunate ones examined. And some returns have a higher likelihood of being audited, including:
Being a sole proprietor with substantial income (e.g., a Schedule C filer with business income over just $25,000 has a slightly higher audit risk; those with overall income over $1 million have a significantly higher audit risk).
Claiming substantial deductions relative to the amount of income claimed (the ratios that put you at risk are not known).
Claiming certain type of deductions (e.g., expenses that require specific and extensive substantiation which many fail to have, such as records for travel and entertainment expenses or car expenses).
Taking a small or no salary as an S corporation owner despite substantial corporate income.
Special Issues for Pass-Throughs
Partnerships with more than 10 partners must be audited at the partnership level; the IRS cannot question a partner’s reporting of partnership items until then. Smaller partnerships can consent to the consolidated audit procedures, which is a more efficient process; partners are notified of the audit but only the tax matters partner (the person designated as such by the partnership) deals directly with the IRS for the audit. If the audit results in any changes, partners are then notified about corrections to their personal returns.
S corporations aren't subject to the uniform audit procedures. The corporation may be audited first or each shareholder can face questions about corporate items reported on their returns.
Overall, when it comes to audits—avoiding them and handling them—the best defense is usually a good offense. Make sure entries on your return match up with income reported to the IRS on information returns. Be sure to have all required documentation to back up any tax deductions and other positions taken on your return in case you’re questioned. If you get an unwanted note from the IRS, address it promptly and bring your tax professional into the loop immediately.
Barbara Weltman is an attorney, author of J.K. Lasser’s Small Business Taxes and J.K. Lasser’s Guide to Self-Employment, and advocate for small businesses and entrepreneurs. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® at www.barbaraweltman.com. Follow her on Twitter @BarbaraWeltman.
The information contained in this article is for generalized informational and educational purposes only and is not designed to substitute for, or replace, a professional opinion about any particular business or situation or judgment about the risks or appropriateness of any tax strategy or approach for any specific business or situation. THIS ARTICLE IS NOT A SUBSTITUTE FOR PROFESSIONAL TAX ADVICE. The views and opinions expressed in authored articles on OPEN Forum represent the opinion of their author and do not necessarily represent the views, opinions and/or judgments of American Express Company or any of its affiliates, subsidiaries or divisions (including, without limitation, American Express OPEN). American Express makes no representation as to, and is not responsible for, the accuracy, timeliness, completeness or reliability of any opinion, advice or statement made in this article.
Host of Radio Show, Build Your Business Radio