Keeping good records can ease the pain of an IRS audit

The sigh of relief a business owner heaves after filing an income tax return may be quickly followed by an unsettling thought: What if I’m audited?

Owners dread an audit not just because they might get a big bill for unpaid taxes, interest and penalties. Audits can also be time-consuming and expensive, in some cases lasting months or even years, distracting owners from running their companies and requiring them to pay accountants or lawyers to deal with the government. But companies that keep good financial records can make the process easier.

The IRS audited less than 1 percent, or nearly 1.4 million, of the nearly 192 million tax returns filed in 2014. That included business and personal returns and audits conducted either by letter or in person, according to the most recent available IRS figures. The audits resulted in an additional $25 billion in taxes recommended by IRS agents, and more than $7 billion in refunds, the IRS says.

In a typical business return audit conducted in person — the kind business owners fear the most — IRS agents examine a company’s ledgers, bank statements, invoices and receipts to see if it reported all its income and if the expenses it claimed are legitimate.

In-person audits often take place at a company’s offices. Tax professionals advise owners not to handle an audit on their own, to instead ask an accountant or lawyer to do the talking to the IRS, a service that can run into the hundreds or thousands of dollars, depending on how much an accountant or attorney charges and how long the audit takes. An owner still needs to be prepared to answer questions that an IRS agent has, says Todd Simmens, a managing partner with the accounting firm BDO.

“You need to be making sure you’re able to explain your business, what you do,” Simmens says.

Robert Barrows learned from three audits in the 1980s and ‘90s that good records were critical. He had to pay $180 in back taxes because of a mathematical error, but his company’s books supported everything on his return. He’s still making sure he has meticulous records.

“I’m too afraid of getting audited, so why take a chance?” says Barrows, who owns an advertising and public relations business in San Mateo, California.

Business returns can be selected randomly by IRS computers if they deviate from what’s considered the norm, the agency says. For example, does the return claim an amount of expenses that seems too high? A company or owner can also be audited if the IRS discovers they haven’t reported all their income; this can happen if the IRS has received a 1099 form reporting income that wasn’t included on the business return. If one partner or investor in a business is audited, other partners may be audited too.

Companies also may be audited if they don’t pay their taxes, says Amy Vetter, an accountant and vice president at software maker Xero. Companies that run up a tax bill attract the notice of the IRS, which will want to know why the government isn’t getting its money.

Dispute leads to audit

Attorney Steven Lesavich was audited because the IRS had no record of monthly tax payments he made over five years. The agency sent him a letter in 2008 demanding payment and warning that his bank accounts could be seized. Although his accountant provided documentation that the payments were made, the IRS didn’t accept the proof. The agency said Lesavich, who practices in Kenosha, Wisconsin, would have to agree to an audit if he didn’t want his accounts frozen, and he said OK, hoping it would resolve the dispute.

The accountant handled most of the audit, but the agent had questions for Lesavich: Had he paid a vendor but not sent a required 1099 form? Did he pay people in cash and not keep records? The answers were no and the questions were unnerving.

“You start to wonder if we missed something,” he recalls.

About two months after the audit, Lesavich got a letter saying the IRS had located his payments. But the experience, which lasted about six months, cost Lesavich a total of $15,000 for his accountant’s fees and revenue lost when he spent time on his tax problems, not with clients. The accountant’s fees were deductible as a business expense, but the tax code doesn’t allow lost revenue to be deducted for service providers like lawyers.

Personal returns

Many owners, including sole proprietors, partners and shareholders in companies known as S corporations, report business income when they file their personal 1040 forms. If there are questionable items in the personal portion of an owner’s return, the business part can also be audited. And vice versa.

Shelley Armato, her husband and their construc- tion software company, MySmartPlans, were audited in 2010 after the couple took a deduction for a $500 donation to a funeral home. The IRS questioned the donation because it hadn’t been made to what’s called a qualified charity; the couple gave the money to help a family who couldn’t afford their child’s funeral.

On the day of the audit, which Armato calls “a stressful time, to say the least,” two IRS agents arrived at the Armatos’ Kansas City, Kansas, office and began examining a year’s worth of personal and business papers. The couple’s accountant handled most of their questions; there were no problems with the company’s income or expenses. In the end, the Armatos got a $600 refund because they’d overpaid their taxes. They had to pay their accountant $10,000 — and were relieved that it was all over.

“It’s one thing you could check off the list and say, the big bogeyman isn’t coming to eat us,” Shelley Armato says.