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How would you cover a $14 trillion debt?  In reality there are only two options: cut spending and/or increase revenue.  Cutting spending is the permanent fix, although it’s not immediate or easily achieved.  Revenues can be increased immediately by reviewing, i.e. auditing, the tax forms already on file with the IRS.  In 2008, for example, there were 39 million sole proprietorships filing Schedule C’s, representing $2.4 trillion in business receipts.  A closer review at these returns will uncover reporting errors, resulting in underreporting of taxes.  Now add interest and penalties, and BAM!  Revenue goes up.

If your return gets selected for review, take a deep breath, exhale slowly, and repeat to yourself that you can pass this test.  Fight the urge to go into denial.  Don’t blow this off; it is a serious matter.  The best advice is to stay cool but develop a solid plan.  Remember, you are dealing with IRS Auditors who will bring their “A” game.  In general these auditors are simply doing a job.  They are probing your business transactions, so try not to get defensive.  Their goal is simple: find errors in your return that will increase the amount of money you owe the government.  Your goal: keep their hands out of your pockets. 

Now that we clearly understand the audit’s goal, let’s begin to prepare—it’s just like preparing for a big test in school.  If you can’t remember how to do this, relax and read on. 

If you had a tax preparer actually complete and file your return, they can help, but keep in mind it is your pocket we are defending, your business, and your records.  You are the team leader, so take charge.  Be proactive; get prepared, and clearly understand your business transactions. 

During my recent review, with my CPA sitting right next to me, the auditor selected my tax preparation bill from the CPA’s firm.  She was looking for personal deductions that may have been taken as business deductions.  Confidently, I handed her the itemized billing for tax preparation services.  The year in question required a great deal of preparation time to complete the Schedule C.  The bill included a short description of each service-- all pertaining to the Schedule C.  The IRS auditor stated that half the bill should be applied to the preparation of the form 1040 and my Schedule “A,” both personal tax forms.  Half of the tax preparation bill was clearly more than was required to prepare the personal forms according to my CPA.  Undeterred by our combined pleas, she reduced my business deduction by half. 

This story illustrates two important points: 1) Your CPA will be of limited help, 2) The IRS Auditor will be looking at transactions that could be classified as personal.  For example, purchases at Costco or Best Buy could be for business as well as personal.  The auditor will be attracted to large purchases from these types of businesses.  Your job is to provide clear evidence supporting business use.

The IRS will select a random year to audit, but they can look at your last seven years of returns.  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 analyze.  If the IRS Auditor discovers a number of errors in the selected year, lookout, they will continue the search.  Remember: it’s nothing personal, it’s simply about money.

You are in a tough fight, but remember the simple goals and get prepared.  I’ll provide you with a great system to help you prepare for the big day.  Next month, I’ll provide 5 steps that will prepare you for the face-to-face meeting and give you the confidence to clearly present your case. 

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

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