You’ve been flagged! How to prepare for an IRS audit

Still, the number of federal audits has doubled since 2000. The IRS doesn’t spend time and money on an audit unless a gain is anticipated. However, auditors have stepped up their efforts this year to examine levels of unpaid business and payroll taxes. It’s part of a nationwide audit of 6,000 small businesses that started in February.

Although it seems common sense, underreporting income and not paying enough tax are two of the main reasons that tax returns are separated from the pack for further review. The red flags often occur around items such as business losses that are reported for several years in a row or a higher than average business expense to income ratio. Failing to report income that is listed on a 1099 form ($600 or more) or failing to file a 1099 for a vendor is a danger zone. You can also be flagged for unusually high charitable donations compared to your income.

About one million of the audits performed last year were by mail. If you get a letter from the IRS or the Minnesota Department of Revenue, don’t wait until the end of the year to show your CPA and don’t panic. Many of these requests for information or clarification are due to simple math mistakes, an unsigned return or even a change of marital or family status from the year before.

For other issues like unpaid payroll taxes or a missing 1099 for a vendor, you’ll need to provide more than a quick response. Here are some planning tips to make your business IRS- ready and -resilient.

1. Have a process.

Do you have a designated person who handles requests from governmental agencies? If that person is you, make sure that you schedule time to respond to the request promptly. If someone else opens your mail, make sure that the person knows the process for requests from the IRS, the Department of Labor or other agencies.

Discuss who will follow up to get more information, handle research for the requested information and submit a response. Before you do any of that, make sure that you apprise your CPA and/or attorney of the request so that you only respond to what is requested – not more and not less.

2. Create a document retention policy.

Every business should have a written policy on the types of records retained and for how long. For tax records, the standard timeline for retention is seven years. However, that timeline can vary depending on your personal or business situation. Make sure that your staff is knowledgeable about what to retain, how and where.

If you have a receipt for a reported deduction, you have done the minimum to cover your claim. You may still have to justify the deduction if it doesn’t match standard tax law. Keeping careful records throughout the year of every business expense and its purpose – and storing them in an easily accessible paper or electronic file – will go a long way toward making an IRS request less taxing.

3. Be honest with your advisers.

Your CPA or attorney can only help you up to the level of your own honesty. If you are aware of what the IRS is questioning, share this information with your adviser so that he or she can provide a strategy for representing you fairly with an auditor.

CPAs are bound by professional standards of ethics to prepare taxes according to state and federal tax law. By signing your return, you are indicating that you have provided accurate information to the best of your knowledge. Maintaining an open relationship with your advisers will allow them to represent your best interests during an audit or other IRS inquiry.

4. Use resources to stay above board.

There are many free business resources that can keep you tuned to areas that the IRS may scrutinize more closely at any given time. In addition to payroll and business taxes, the IRS also watches changes in taxpayer status, an unusual swing in income, dependent claims and creative business deductions.  For example, due to past taxpayer abuse of deductions for business mileage, the IRS has targeted this as an area for extra monitoring in recent years.

To stay up to date, you can visit www.IRS.gov and subscribe to e-mail tax alerts and news. You can also receive information through various CPA organizations, including the Minnesota Society of Certified Public Accountants (www.mncpa.org/taxhelp) and the American Institute of Certified Public Accountants (www.aicpa.org).

There is also information available about filing extensions, unpaid tax payment options and relief from tax liens. Become an educated taxpayer in order to understand what you can and can’t do to reduce your tax burden. If you are unsure, consult a CPA.

5. Know your rights.

Of course, there are limits to what the IRS can request. You should understand your rights as a taxpayer to professional advice or representation. For example, you don’t have to respond to an IRS request directly, but can give your CPA the legal authority to handle the request for you.

Keep in mind that as your business grows and becomes more successful, the IRS pays more attention. According to IRS enforcement records for 2009, your chance of an audit is about 3 percent if your personal household income is above $200,000; it rises to a 6 percent chance as your household income reaches $1 million.

Follow these steps to be prepared for success. Then, if you join that exclusive club of business owners who pique the government’s notice, you’ll be able to respond with less hassle.