diagram of needed audit process

The best way to prepare for an audit is to understand ahead of time that you ARE going to get audited, and therefore have your company financials in decent order to be able to do the following:

  1. Justify expenses as true business expenses. This means actual receipts, not credit card statements, with an understanding of how those items were used in the business.
  2. Identify those items that are in the grey area. I am considering that you aren’t purposely doing things that are against the law.  The Tax Code draws a line in the sand about what is a legitimate deduction or expense, and what is not.  But that line is pretty fuzzy, and many of those are open to interpretation by the IRS Agent.  And, he or she has broad latitude to do just that.  There are things that are clearly acceptable within the code, things that are subject to interpretation (that grey area) and things that are specifically excluded by the code.  Know where your business stands in those three areas.  Specifically, know what things are in the grey area, and which are out of bounds.
  3. Segregate those expenses that the business made that were done for your personal benefit. You may be able to convince the Agent that there was a “reason” that they are business related, but be prepared – that’s what they’re looking for.
  4. Have copies of back up documentation for the expenses that you have made, and know where to readily put your hands on it. Every check should have an invoice attached to it, so that the Agent can quickly identify the information he needs.
  5. Document the number of miles you put on your car for business purposes. Do you have a log book?  Well you should, because that is one focus point of many audits.

The thing to remember is that the agent is like any salesman or bill collector.  He is judged by the amount of money that he’s going to collect from you during the audit.  There are certainly businessmen that approach an audit by being tough as nails, delaying or being unable to provide information, providing illegible copies or backup that doesn’t match the information the Agent is looking for.  That kind of activity will just get the agent upset.  If he’s on your side (and he never is – the actual question is “How much of an adversary is he?”) he may be willing to forgive some things that are in that grey area.  If you make his life difficult, he will likely dig in his heels, and make your life more difficult and the audit result more expensive.

Remember, he has a boss that is looking for him to have a successful result after spending time with you.  And that doesn’t mean that he can readily come back to the office and say with a bright smile, “wow, what an honest business, I couldn’t find anything that they did wrong!”  The more time he spends with you, the bigger the pot of gold that his boss is going to expect to have when all is said and done.

Any expenses that you can’t justify as a company expense will be disallowed by the Agent.  That means that your company will have more income, and have to pay more in taxes.  But, worse than that in my mind, is when the Agent discovers that you’ve used the business checkbook to provide for personal gain.  You’ve bought yourself “things” or took “trips” that have been identified as business expenses, which were really thinly veiled ways of reaping a benefit without considering it income.  The agent is going to start preparing a listing of those things, and the small dollar amounts will really add up.

If you have multiple companies that work together, make sure that the intercompany accounts match.  One client we worked for had several companies that did business across the desk from each other.  One company primarily funded the losses of the other company.  The intercompany balance sheet accounts didn’t match between the companies.  As the years went on, the owner continued to “forgive” the debt of the losing company, without noting them on the books of either company.  The end result was that the IRS Agent identified that mismatch, which became a tax obligation of the owner.  It amounted to a large bill.

In another case, the owner of the business had been doing accurate recordkeeping for years.  At the end of a month of working at the company, the Agent declared that the owner owed $20,000 in back taxes for a variety of things that we could easily document as legitimate business expenses.  The Agent declared that, “I’m sure that I could spend more time here working on this, but I would probably find enough questions that I would want to audit the two years before and two years after this particular year.  Who knows what I might find in those 4 years of tax returns and financials!”  Under threat of a continuing audit covering 4 more years, we agreed to make a payment to the IRS for a lesser amount, saving us considerable time and sweat while he pored over years of reports, trying to justify his time.

The upshot is that you need to have a number of things that you are willing to give up.  What expenses are you willing to give the Agent (after he finds them) as being a bit aggressive in the company’s recordkeeping, and you might owe taxes on that issue.  Your willingness to give in on some things early in the audit might save you significant time while he combs through your records to justify his time in being there.

Because I promise you.  No matter how well you have done with your recordkeeping and documentation, he needs to justify his time – and he will.

CFO Simplified is your strategic financial partner to drive growth, profitability and value into your business. For more information and examples of how CFO Simplified  has helped clients achieve these objectives, please review the services offered and case studies available on our website.

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