The IRS wants business owners to open their books. Now what?

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Americans are breathing a collective sigh of relief for making it through yet another tax season. They may want to hold off on spending that refund. For tax accountants and some businesses, April is just the beginning.

The Internal Revenue Service (IRS) is now going through the filings and looking for discrepancies, missing numbers, and yes, the occasional unlucky random soul. It’s time for the audits.

But what does an audit actually look like in practice? What steps should a business owner take when the IRS comes knocking? To find the answers to these questions and more, I reached out to Kelly Erb, a tax attorney who runs the TaxGirl blog and has spent time on the other side of the desk, conducting audits for the IRS.

Below are excerpts from our conversation.

What percentage of small businesses get audited each year?

That data is really difficult to extrapolate because the fact is, most audits are targeted. The random audits, which is what people are scared of, are more uncommon than you think. The rate is two percent for randomly selected individuals, some of which are small business owners. If you get audited, most of the time you’re going to know why.

Is there more than one kind of audit?

There are two different kinds of audits: The in-person audit, which is what a person normally thinks of and gets portrayed in the movies. These days, most are paper audits where the IRS sends you a letter that says “send us this” or “we believe this is wrong, tell us why it’s not.”

However, it’s important to note that they will always reach out by mail regardless of the type of audit. No one is going to call you and tell you that you’re being audited—that’s a common scam.

What usually prompts an audit?

As a small business owner, there are two common things the IRS looks at. The first is a form mismatch. For example, say that you received $10,000 in income but your 1099 was issued for $20,000. The IRS has a computer program that’s looking to see if you reported the 1099 interest or if there’s a missing W2.

The other common one is inconsistencies. Like most companies, the IRS runs metrics. They are looking for patterns, behaviors and industry standards. If you are a writer and make $5 million but you’re not JK Rowling, they’ll say that isn’t normal. Now, if you run a business and report $20,000 in profit but one year you have a $50,000 loss doesn't mean you’re going to be audited. If you do that three years in a row, that will flag their system. People have to eat, so if you are losing money year after year, the IRS is going to scratch its head and wonder why you aren’t making some changes.

Ok, so the IRS comes knocking. What do you do?

If you get the paper audit, it may just be one question and you already know the answer to it. Going back to the interest example, say you get a paper audit where the IRS made an adjustment and is giving you an opportunity to respond. Oftentimes, you’ll say you’re right, I forgot about that form and you can accept the adjustment and make the payment. Sometimes it’s even in your favor. I’ve had clients who have received refunds for adjustments. They forgot they made estimated payments and didn’t record them.

The IRS gives you a chance to respond to the paper audit. You can make your argument in writing and either they accept or not. Or they could ask for more documentation. Those are the common outcomes. If you have an error or something gets their attention, the IRS is not going to immediately ask for three years of records.

If you’re a small business owner and the numbers don’t add up from year to year, the IRS may ask to see your books. In those situations, I typically tell people they should retain counsel.

In my experience, when an in-person audit happens, they are looking for something. There is a loss that doesn’t make sense or an office expense that seems high. The audit starts out with a specific ask, but the taxpayer in my experience panics, which is what a lot of people do. They’re scared and they over talk. An attorney or tax professional can show up on your behalf and address the reason for the audit but are not emotionally involved.

When does an audit take place? How long does it last?

We typically call summer “correspondence season.” The IRS will send out a notice during this time if there is a form mismatch or misreported records. They’re not going to wait three years to tell you that you forgot a 1099. Most audits are resolved pretty quick, but it also depends on whether or not you agree with the findings.

How can a business owner avoid getting audited? What are your tips and tricks of the trade?

One thing is to keep really good records and make sure they make sense at tax time. Another is to not use round figures. People do this all the time, but the world doesn’t work in round numbers. They’ll report the phone bill but record it as $300 when it was actually $281.33. That’s statistically not likely, so be sure the numbers make sense and that they’re not out of industry standards.

I recommend people annotate their records. If there is a loss, there’s a reason. For example, if you have a $25,000 loss for litigation, instead of writing legal fees, write “patent litigation” on the records. Cash businesses, in particular, need to keep excellent records. It becomes a question of if you accurately reported the amounts. When you make a deposit, keep those receipts and have an explanation of what they are. If one week had a lower amount because of a snowstorm, note that in your records.

I’ve spoken with several small business owners, and what I’ve learned when it comes to avoiding an audit is to invest in a tax professional. And not just someone who shows up during tax season. You want a go-to person, someone you can talk to on a regular basis. That person will say, for example, “Hey, you normally have this interest payment but I’m not seeing it. Did you close that account?” There’s a value in that that can’t be overstated.

Bonus question: Now that tax season is over, how can businesses prepare for the next one?

If anything was particularly painful, odd or stressful during this filing season, think of what you can do to not repeat that next year. I would recommend taking note of the things that stand out in your mind because it’s fresh right now. This is an excellent time to regroup, look at what didn’t you love about tax season and make those immediate changes because that's the stuff you can identify.

What's your take? Do you have advice for business owners who are going through an audit? Join the conversation below.