Are You Ready For an IRS Audit?
Self employed business people tend to be squarely in the cross-hairs when it comes to tax audits. Even the NY Times recently wrote an article in which they stated that "People who are self employed often fail to report all of their income properly. The reality is, with almost 9,000 pages of tax code in the United States, it can be difficult to keep up with everything, particularly when things tend to change from year to year. Unfortunately, IRS auditors will often not accept "Well, I did not know..." rather they expect people to comply and remain current with reporting expectations. Fortunately, most of us are only responsible for a very small portion of the tax code.
Needless to say, whether it be with personal finances or business finances it is important to keep accurate records and well as to review them on a regular basis. Most banks and credit card companies maintain an online record of your transactions which you can download to your computer or even paper records if you wish. Financial management software packages such as Quickbooks can help you stay organized and keep track of even daily receipts.
Proactively, you can reduce your odds of an audit by:
- Being honest on your return and report your income
- Avoid high number of deductions compared to your income. If you deduct more than 1/2 of your income, this will raise flags.
- The more precise you can be, the better. Be careful with rounding numbers. Rounding $2000.01 (one penny) is certainly ok; rounding $2,100 to $2000 may be caught with an audit.
- Consider forming a LLC rather than a sole proprietor or even a partnership. This will also lessen your liability in other areas of business.
- Be careful if you have a high income and claim EITC. This can be a red flag for auditors.
- Seriously consider a tax professional or at least the VITA (Volunteer income tax assistance) program as your income increases.
- Keep your receipts in a organized file! Remember that many companies keep a detailed list of your purchases for several years and you may need to contact them in some cases. Even small amount may add up over a period of a year.
If you are audited, don't panic and carefully read the information that the IRS wants from you. Many audits are done by correspondence and you may not even have to go sit in front of an auditor. HOWEVER.. now is the time to get professional advice. If not, you may do or say something in person or in writing that may cause an auditor to look deeper than what they original audit has intended.
- If you are requested to appear in person, you can bring your tax professional with you. Upon filing a legal power of attorney, you may even get a tax professional to appear in place of you.
- Be nice. If you are sitting in front of an auditor and throw a pile of receipts at him/her, things are likely to get worse. Auditors love very organized people and the process will go much smoother.
- The IRS allows you to re-construct your tax records if you do not have a receipt for a particular deduction. In the age of the internet, it may only take a few minutes, even during an audit, to retrieve something that you do not have in front of you.
- Deliver what is asked for, and nothing more. If you provide additional information, it may slow down the audit or may be cause the auditor to head off in another direction by raising a red flag.
- If you are claiming part of your home as a business, the auditor may want to home. Although you do not have to let him/her within your property (without a warrant) he/she may dis-allow your home business. Try to have an audit at your tax professionals office if at all possible.
- Be careful with charitable donations. The rules can change from year to year. Often you can only donate raw materials, and not your time. Donations to organizations such as Goodwill (get a receipt) may add up over a period of a year.
- State and federal laws may vary. It is even possible to be audited by your state for things such as sales tax.
In summary, being prepared with your records and being somewhat conservative in what you claim as deductions will often work in your favor during any tax form review. As your annual income increases, the need for a tax professional to review your records will also likely increase.