Income tax audits are intimidating whether you are being audited personally or as a business owner. There is a right way and a wrong way to handle an audit by a state or federal taxing authority. It is easy to dig a hole for yourself, but awfully hard to get out of that hole.
Whether you attempt to handle an audit on your own, or opt to involve a professional who is experienced in these matters, there are some things you should know as you embark on your journey. I don’t ever suggest that a taxpayer submit to an audit alone. It is very helpful to have an experienced professional along for the ride. Not only can the accountant or attorney help you complete records requests, she or he can also act as a buffer between the taxpayer and the IRS.
The process of an audit is often one big negotiation. It is a give and take between both sides. Ultimately, both sides want the case closed, and the faster we can get to that point, the better. (Preferably with the least amount of pain for everyone involved.)
Attitude Is Everything
Okay, attitude really isn’t everything in an audit, but it sure can help. Uncooperative and disrespectful taxpayers usually have a much harder time getting a favorable result from an audit. Make it clear to the auditor that you want to resolve the situation and pay what you owe.
Being belligerent doesn’t get the taxpayer anywhere. I have always found that showing respect for the auditor is the best policy. We both have a job to do. Neither one of us is right or wrong all the time. Demonstrating cooperation and flexibility can help a lot in contentious situations.
Silence can be golden during an audit. Volunteering information is not usually helpful to the taxpayer. In fact, it can be harmful, because it may give the auditor clues to additional items or tax years that should be examined. Answer the questions that are asked, no more and no less.
It is always helpful for the taxpayer to be familiar with the tax return under audit. Special attention should be paid to specific items that the IRS is questioning. Although it inevitably always happens, it is never fun to be caught off-guard by a question you weren’t expecting.
To the extent that you can allow your representative to answer the auditor’s questions, it is advisable to do so. An experienced accountant or attorney can provide the auditor with the best answers to facilitate the audit process. There are correct answers that may be better than other correct answers because they do not raise new audit issues.
Presenting the auditor with well-organized records is always helpful. It is recommended that the taxpayer present receipts by category, and that means adding up the documentation to see if it corresponds to the numbers on the tax return.
What Can Be Audited?
In theory, any number reported on a tax return is open to audit. This means that you could be required to provide documentation in support of any number you have reported. In reality, tax auditors often limit their inquiries to certain items. Sometimes those are the largest reported items, and other times the focus is on items which have the most risk for improper reporting.
I always suggest trying to pin down the auditor regarding the items in question. Don’t enter into an audit assuming all deductions are being audited. Ask the auditor exactly which items are under audit, and provide documentation only for those items.
The first and foremost goal of a taxpayer and her or his representative is to prevent scope creep. By this, I mean that it is in the taxpayer’s interest to prevent the audit from expanding to additional items or years. When an auditor encounters problems, it can cause her or him to look into more items.
Though an auditor usually limits questions to selected items on a tax return, a quick way to start digging a hole is to appear uncooperative in regard to the items that are being questioned. Failure to provide documentation or adequate explanations may encourage the auditor to scrutinize additional items.
Sometimes the scrutiny is because the auditor suspects you don’t have documentation. Other times, it is done to be a bit punitive. In either case, the auditor has the right to ask about any of the items on the tax return.
The effects of not cooperating with a tax audit are severe. The IRS will assume that you have something to hide, and the auditor may likely expand the scope of the audit. Even worse, the IRS will conduct the audit without you, and can essentially choose numbers. The auditor will look at available documentation, and probably pick the numbers that create the largest possible tax bill.
It is always up to the taxpayer to prove where a number on a tax return came from and supply supporting documentation. In the event that documentation is incomplete or missing, it is the auditor’s prerogative to disallow part or all of the deduction.
You are entitled to ask the auditor why she or he wants to see a particular document. You may also ask them to specify which items they would like to see. Make them narrow down the documentation, so that you’re not left with providing everything under the sun.
But by all means, do not refuse to provide the documentation for items under audit. If you don’t have any documentation and can’t get any, that is something that should be discussed with the auditor. There might be a compromise or alternative documentation that can satisfy the auditor’s questions.
Do not bring to the audit anything that is not directly related to the year being audited. While an auditor is typically limited to examining items for only the year under audit, if you present materials for other years, she or he is allowed to look at them.
Minimizing the Damage
As you can see, the issues surrounding a tax audit can become complex. Additionally, there are the tax rules as they are written, and there is the practical application of them. Auditors do have discretion when examining your documentation and discussing items with you.
It is advisable to develop a good working relationship with the auditor. I’ve found that utilizing a “problem-solving” approach to an audit works well. The auditor has a job to do on behalf of the government, and I have a job to do on behalf of the taxpayer. Let’s decide together what information and documentation will satisfy the auditor.
The process of an audit can seem very slow and very painful. There may be few good parts of audit, other than the end of it. Keep in mind the auditor is required to make any adjustments found to be in the taxpayer’s favor. The taxpayer may also bring up deductions that were not previously claimed on the tax return.
Stand up for your rights, but maintain a good attitude and show cooperation throughout the audit. When in doubt about your duties, rights, and documentation, consult a professional who is an expert in the audit process.