The Internal Revenue Code requires businesses to maintain records of their activities including invoices for services rendered, bank records and invoices for expenditures made for business purposes. It is also wise to have a system of accounting, a spreadsheet with income and expenditures or an accounting system such as QuickBooks or others. In the event your company or your client is audited by the Internal Revenue Service, these records become very important. IRS statistics show that in fiscal year 2017, the examination of returns was .5% nationwide with 70.8% being correspondence audits and the remaining 29.2% was field audits.
In recent years, there has been an increase in civil field audits (representing office audits and field audits) where the taxpayer is asked to come to the IRS office (Office Audit) or a Revenue Agent makes contact (Field Audit) with a business for the audit. Experience has shown that Office Auditors are conducting more business audits. These are dangerous audits; the auditor has time constraints and is generally not trained or sophisticated in small business matters. If you have the records they are looking for and can answer their questions, then you probably are safe.
When you or your client receives a written notice of an Office Audit or Field Auditor your blood pressure will increase. You will generally receive a request for business and personal records, and your blood pressure will again escalate. Do not take the request for documents lightly. They will ask for business and personal bank records for the period under audit and can possibly audit other years.
Hopefully, you have prepared your records on an annual basis for the possible presentation to the IRS auditor and to be able to timely respond to their request. A little preplanning can keep you lower your blood pressure. Accurate records and timely responses may also establish credibility with the Auditor.
There is a common statement in Law Enforcement “you can beat the time, but you cannot beat the ride!” Unfortunately, with IRS the “ride” is painful, and everyone experiences it upon the receipt of the IRS notice for audit unless they are prepared.
In the civil audit situation, the taxpayer has the “burden of proof” as to identifying taxable or nontaxable income. The same for business expenditures vs. nonbusiness expenditures. At first, the auditor will look at deposits to business and personal bank and brokerage accounts. Unless identified on the bank statement differently, the auditor will consider all deposits as taxable income. The records should be able to identify all income and non-income sources, reimbursements, transfers between accounts, distributions from your Schedule C, a Partnership, or S Corporation, gifts from parents and inherited funds, etc. If they cannot identify them, the auditor will consider those monies income.
One way to avoid this trauma is to maintain business records of income and expenses and in this electronic era is to scan each item and to save them as a PDF into your accounting records. Consider creating a folder on your computer for each year and each company (2019 Business Receipts). You can save the records in paper with a separate folder but going paperless is best! Try running a redundant scanned and copied records system at the beginning of a new quarter. You will notice that it is easier to scan documents at your desk. Regardless, of how the records are kept for income the payments representing all income should be copied (printed or scanned to PDF).
Also, keep records of where funds are transferred from your business bank account to a personal account and vice versa. Records of transfers in and out of your account can be traced generally through email notices from your bank, which can be saved as a PDF by date or paper. Records for expenditures should be in the form an invoice or emails with the payment notices, and a copy of the check. Remember the burden of authenticating business expenses is upon the taxpayer. Records must be maintained, or the expenditures may be disallowed. These records if in paper should be printed and stapled together and kept in an organized folder by check number. If done by PDF, it would be best to have the check and invoice scanned and combined and maintained in two separate subfolders (2019 Checks – By #) maintained in the check number order and the individual file names should be styled Check Number – Payee, date & amount and (2019 Checks A-Z) in alphabetical order and the individual file names should be styled Payee, date, amount & Check Number) to help with quick access to the checks and the associated invoice.
It is my experience that some IRS Office Auditors consider as income the distributions from a Schedule C business or S Corporation and some have not allowed credit for the income reported on the Schedule C or Form K-1. This is a lack of training and experience on the part of the auditor and is a prime example why having an experienced tax representative with you for the audit can be beneficial and possibly the best money you or your client can spend.
Recently, a small business client was called in for an Office audit, and the taxpayer went to the two-hour meeting without a representative, provided some requested records and a month later the taxpayer received the Audit report that showed a liability of $100,000 in tax and penalties. The taxpayer and his family were devastated, and their lives turned upside down. The auditor report showed the Auditor was assessing tax on all deposits and had disallowed all business expenses. They hired an experienced representative, signed a Power of Attorney, and the representative contacted the Auditor. The representative provided additional substantiation and explanations for the deposits and expenditures records. The Auditor was finally satisfied with the records provided and the categorization of the deposits were accepted. A small amount of expenditures were disallowed. The result was that a small tax liability was assessed. When going to the IRS for an audit don’t leave home without your representative.
Most Small business men and women are busy doing business, selling their products or services, and generating income. They incur ordinary and necessary business expenses to acquire the business income. By the same token, most do not maintain good records, and some run personal expenditures through their business and live beyond their means. These taxpayers may experience the “ride” with the IRS Auditor. With good records to start combined with the expertise of a reputable return preparer, CPA, Enrolled Agent, or Attorney a taxpayer’s life as a business person will be easier.
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