As an attorney helping clients with audits, I see simple mistakes turn into big problems. If you own a small business, you need to follow the rules of record keeping and if you want to save attorney fees during an audit for no reason at all. I get a lot of questions about audits, including the procedure and timing.
Everyone faces audit risk, but especially high net worth individuals. Often small businesses that are doing well run into problems as a result of inadequate bookkeeping. As a result of the end of COVID-19, the IRS has repeatedly announced increased tax audits.
IRS Audit Selection Process
The IRS selects tax returns for examination using 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 to small businesses and the self-employed. Computer programs show insufficient income, excessive deductions such as home office and mileage deductions, and large travel, meal or entertainment expenses. The IRS also receives notifications from banks of any transactions that exceed $10,000 to the IRS.
In addition, each year the IRS publishes the “Dirty Dozen List.” Transactions on this list are known as consistent fraudulent behaviors, and the IRS will pay attention to tax returns with anything on the list. Currently, the Employee Retention Credit (“ERC”) tops the list. The IRS plans to audit the majority of businesses that have filed ERC claims because there have been promoters around the country who have been forcing unauthorized people to claim the credit.
Another big target is cryptocurrency reporting. Fuel duty relief is for on-highway business and farming use and as such is not available to most taxpayers; However, many taxpayers mistakenly claim the credit. Over the past five years, the IRS has also consistently targeted conservation easements. In addition, the IRS began restricting federal income tax evasion related to cryptocurrency transactions in 2019. Like cannabis and cryptocurrency, the rise in popularity of online gambling has led to increased IRS scrutiny of gambling revenues. .
Finally, another major avenue through which audits are conducted is through whistleblower reports or referrals. Often a disgruntled employee will report suspected tax fraud activity, especially since the IRS and most states offer rewards for reporting taxpayer fraud.
However, the odds are in your favor if you are a small business, you should always try to stay compliant as many little things can lead to an audit. .
General audit process
Most taxpayers do not understand the full power of the IRS. First, the IRS will generally send notices and submit them to the revenue agent. The Revenue Agent then sends an Information Document Request (IDR) to request a list of documents. The IRS has a list of documents they typically request, which includes receipts, insurance statements, medical records, journals or diaries, tickets, and other documents related to the tax deduction being claimed.
Next, the audit involves interviewing the taxpayer, usually the managing shareholder or partner of the business. This interview allows the IRS to understand the background of the business and any follow-up questions regarding the first IDR. Preparation prior to this interview is important, including review of previous responses to IDRs, including previously provided documentation. Revenue agents generally want to see all books and records for the past three tax years.
After the interview, the Revenue Agent may send further IDRs or conduct a field visit. A field visit is when a revenue agent visits the business and may contact employees. During this visit, they want to make sure that your business is actually engaged in the activities that you described in your interview.
Once the Revenue Agent has completed the investigative process, they will issue a report and hold a closing conference. If you don’t agree with the report, you can ask to speak to their manager, file an IRS appeal, or even file with the USTC.
Things to remember
I always caution people to contact an attorney immediately after receiving a notice from the IRS. It is very important that the attorney conducts all communications and attends the initial interview. First, the attorney knows why the revenue agent is asking specific questions. Second, it can suppress tension.
Audits are evasive – they ask detailed questions about the business over the past three years. The interview may be in person or over the phone, depending on the revenue agent. Revenue agents are there to make sure that people don’t take advantage of the system. As a result, they step in and are investigators trying to track down your business, and possibly themselves, for every penny earned over the last three years.
If the revenue agent feels for any reason that you are lying, he will expand the examination to include not only the previous three years of business, but all other businesses in which you have an ownership interest, as well as your own. Income taxes. In addition, if they believe that you are not answering honestly and providing all documents, under Section 7602, the IRS has the authority to contact third parties. They must send a message before engaging in this activity, but it is possible.
As a result, it is important to always keep accurate and clear records of your books. If you can easily provide documentation about everything, the process will be quite simple and easy. Meanwhile, if things aren’t clear, you could end up spending more on attorney fees than you owe on taxes.