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In a tax audit, the IRS Auditor’s job is simple: find errors in your return that will increase the amount of money you owe the government.  Your goal is also simple: keep their hands out of your pockets (or at least from going all the way to the bottom).  Remember, they will be prepared.  Bring your “A” game by preparing thoroughly, using relevant IRS regulations as support for your claims.  The IRS will be using those same regulations.  This is where competent tax advice from a CPA versed in tax regulations will be able to help.  If you discover serious tax problems during the audit preparation process, you may need additional specialized professional assistance beyond this article. 

Remember two important points: 1) Your CPA’s help is limited to understanding and interpreting IRS regulations, 2) The IRS Auditor will be looking at transactions that could be classified as personal.  Purchases, for example, at Costco or Best Buy could be for business as well as personal use.  The IRS Auditor will be attracted to large purchases from these types of businesses.  Your job, not your CPA’s, is to provide clear evidence supporting business use.  It is your pocket we are defending, not theirs.

The IRS will select a random year and even specific income/expense categories to audit.  They can look at all of your income/expense categories for up to seven years.  You don’t want to pull data for seven years.  How you perform on the selected year will determine the number of years they will look at.  If the IRS Auditor discovers a number of errors in the selected year, lookout!  They will continue the search.  It’s nothing personal; it’s simply about money.  Your money!

Step One - Organization

Get a big three-ring binder; add 15 tabs to organize the IRS requests, your complete return, with a separate tab for your tax returns, specifically, Schedule C, Form 1065, 1120 or 1120S.  The other tabs will cover the months of January through December.  Now get 12 clear binder pockets to use for holding the actual receipts.   Assemble the binder, tabs and pockets.  Insert the two-page cover letter with the “Information Document Request,” IRS form 4564 behind tab 1.  Behind tab 2, put a copy of your tax return, and behind tab 3 put a copy of the specific schedules and forms. 

Step Two – External Statements

Gather all of your bank and credit card account statements by month.  If you don’t save these monthly, don’t worry.  You can go online to your bank and credit card companies’ web sites and login to your account.  If you don’t have access to these accounts, go through the process of getting access.  There will be a section named “history” or “statements” that will allow you to print statements by month for the previous seven years.  Select the audit year, and print the statements.  Arrange these statements in month order and insert behind tabs 4-15.

Step Three – Internal Statements

If you don’t have an automated accounting system for your business, look out.  Bringing in a box of receipts makes an IRS Auditor see dollar signs and easy money.  An automated accounting system allows you to easily provide a detailed Profit & Loss statement, which is the detailed summary of your businesses transactions and how they were classified, i.e. either income or the use of an IRS recognized business expense.  While income classification could be an issue, most of the time proving that expenses were made in accordance with IRS regulations is the real issue. 

If you don’t have an automated system, either get one and put it in place before the audit using account statements for checking/savings/credit cards, as the basis for populating the system, or build one by hand using a spreadsheet application.  This sheet is extremely important.  It forms the basis of selecting transactions for review.  It also demonstrates how you classified each transaction, assigned as either income or expense.  Put this sheet behind your tax returns in tab 3.  The IRS Auditor may disagree with how a transaction was assigned, but moving it from one expense category to another does not take money out of your pocket.  You win!

I’ve prepared a Profit & Loss Detail sheet for your use, which you can download here.

Step Four – Documents

“Credit card statements, bank statements, and cancelled checks generally only support that an item is paid but rarely support the expense is allowable under the law” .  In addition to statements and cancelled checks, a copy of the invoice or receipt and a brief description of how the expense was incurred and the business purpose will be necessary.  A description of the expense and the business purpose can and should be part of the “Profit & Loss” detail outlined in Step 3.  This means pulling together receipts or invoices are the last documents you need to assemble, but this can take some time.  If you haven’t kept receipts and made purchases online, most companies have a purchase history available online, conveniently going back seven years.  If all else fails, use your statements to identify expenses that need supporting documents, then contact these vendors requesting copies.

Step Five – Matching

Place your invoice or receipt into the clear binder pockets behind the month and bank or credit card statement, in date order, when the transaction was recorded (Use additional pockets if needed).  If you can’t gather all of your receipts, make sure that you have all of them from companies that could result in assignments open to interpretation, i.e., business or personal.  Although it depends on what category the IRS is reviewing, use 5% of gross sales as a significant amount.  A purchase from, let’s say, Best Buy or Costco in an amount equal to 5% of your gross sales will be a sure target for the Auditor.  Make sure you have good supporting documents and a business explanation for that expense. 

When you arrive on time for the audit with your binder in hand, you can feel confident, ready to win the war over your money.  In this war there will be lots of battles, and you may not win them all, but following these steps will help to ultimately win the war.  You win when the IRS Auditor does not want to review additional years and maybe an additional amount of your money is due.  You win big when no review of additional years is required, and the IRS owes you money!  Unfortunately, a win means that your preparation time does not get covered.  Take comfort in the fact, any win means you dodged a bullet!

Let me know if you have any comments, questions, or suggestions.
Write David W. Weatherholt at david@bnewsviews.com

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