February 11, 2020 | 6-minute read (1088 words)
As a business owner, it's important to understand why you would get audited, what happens if you get audited, and how to prepare for a tax audit. There are probably a few things as likely to put a founder, or anyone, on edge as getting a notice from the IRS that you’re about to be audited. Scary as it might seem, and it can certainly be daunting, there are ways to minimize the pain, if not the time and expense, involved. To help you learn how to prepare for a tax audit on your business, here are the three best tips to prepare for getting audited.
How to Prepare for a Tax Audit on Your Business
1. Read all correspondence and respond promptly to IRS requests
It’s understandable. When you’re busy running your business, getting to product/market fit, and trying to raise funds, an audit notification can seem like the last thing you have time for. But ignoring communications from the IRS or procrastinating on responding, are both really bad ideas.
For one thing, if you fail to review and respond to tax audits, the IRS can automatically disallow deductions you claimed on your returns. You could suddenly find yourself dealing with an unexpected tax bill. You’ll also open yourself up to extra penalties and fines for missing response deadlines, or even potentially trigger extra scrutiny from the IRS. And that’s the last thing you want to do.
Your letter will show the deadline the IRS has given you to respond to. If an IRS deadline is not doable for you or if you're not sure how to respond to the IRS’ requests, talk to your company tax preparer. Ideally, you already have a personal relationship with a tax professional who has legal standing to represent you before the IRS, such as an enrolled agent, CPA, or tax attorney. If you don’t have a trusted professional to turn to, before you commit to one, make sure s/he is experienced in managing audits for small businesses/startups, understands your industry, and offers a comprehensive range of tax services.
2. Get organized
The best method when it comes to how to prepare for a business audit is simple: good old fashioned organization. There are a number of reasons your tax returns could get selected for an audit. For example, your deductions might seem suspiciously high, the IRS might suspect you underreported income, or you recorded high losses. Another reason for an audit could simply be what the IRS calls “random selection,” also known as bad luck.
The IRS audit letter you get will spell out what kind of audit you’ve been selected for — by mail, in-person, or a field audit (the most extensive) — and list the documents you need to provide. Read it carefully, then start pulling your receipts and documentation together.
You should be able to ist in order all expenses greater than $50. Your startup expenses will be much easier to track if you’re already using a good record-keeping system and/or you have a startup accountant on deck. But don’t despair if you have neither.
The IRS accepts electronic records like credit card and bank statements. It will also accept reconstructions of your expenses from accounting records, entries from your business calendar, invoices, and cellphone records, as valid receipts for transactions as long as they provide “sound and reasonable” estimates of your income and expenses.
If you’ve been less than organized, the hassle of having to go back through and match your expenses with all the deductions you claimed (or do it for the first time), can be seriously deflating. But in addition to the unnecessary distraction from your business, there’s another incentive to clean up your act for the future. A history of not keeping formal receipts can be a big red flag to the IRS that you’re not on top of your financial management, and that could result in a wider audit.
3. Know your rights as a taxpayer
It’s important to be aware of your rights when laying out a plan for how to prepare for a tax audit on your business. Your rights include knowing how the IRS will use your information. They also include the right to appeal the auditor’s decision. The IRS can and does make mistakes. You could find that the IRS accepts your returns as originally calculated. Or, you might wind up at odds over what the IRS says you owe. If you disagree with the auditor’s findings, you are entitled to request mediation or file an appeal for reconsideration.
If it turns out you are on the hook for a tax underpayment, but you don’t have the funds to pay in full, you can apply for a payment plan. Just be aware that it’s up to the IRS to accept or reject your request, and you’ll have to pay interest on the amount you owe.
You could also try to settle with the IRS for less than you owe. That’s known as an offer in compromise. And just as with payment plans, the IRS can approve or reject your offer.
One thing we haven’t mentioned, but goes without saying is that hiring a tax professional is the way to go here. Not only will having a professional help you make it less likely you’ll trip up and make mistakes that could cost you, for instance by giving the IRS more information than it has requested, it means you can keep your main focus on job number one: running your business.
Following these steps for how to prepare for a tax audit on your business doesn’t guarantee an audit will work out in your favor. But knowing what to expect from one and how to prepare should help ease the stress, could expedite things, and get you through the process with much less hassle.
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About Early Growth
For over 15 years, Early Growth has provided early-stage companies CFO Consulting Services, Accounting for Startups, Taxes, and 409a Valuation. We saw a need in the marketplace for a service that would allow founders to still focus on business while building a healthy financial story. Our Outsourced CFO, Outsourced Accounting, and R&D Credits services have helped many companies grow.