Before we say anything else, we want to emphasize that the best way to prepare for a business tax audit is not to get audited at all — be sure to review our previous articles on tax preparation and tax deductions to make sure you’re checking all the boxes you need to in order to avoid this outcome. Good bookkeeping, transparent accounting practices, and quality financial planning should allow you to be ready for the IRS audit process, but you can’t always prepare for everything. Nobody is perfect, and you may very well just get unlucky, so here’s our tips on how to prepare for a tax audit, just in case.
Types of IRS Tax Audits
Not all audits are created equal, and some of them are more invasive and disruptive than others. Knowing what sorts of audits the IRS employs and what each of them entails can help you prepare. Here are the main types you are likely to encounter:
- Correspondence audit: these audits are relatively limited in scope, and involve letters or phone calls from the IRS to a representative or officer of the organization (something that a good CFO will probably be able to handle). Most audits are correspondence audits, and even if you do get selected for one, if you’ve done your due diligence, you should be able to clear up any misunderstandings with a minimum of disruption.
- Office audit: the next step up, this involves the IRS bringing in a representative of a company and asking a specific series of questions regarding income, deductions, and other tax-specific matters. These can be random, routine, or triggered as the result of errors on a businesses’ returns, tax payments, or deductions. Generally, if you have the right documentation, these are also fairly easy to resolve, but do involve a trip to an IRS office.
- Field audit: a field audit is the most disruptive and the most serious type of audit, and generally only triggered by serious errors or suspected fraud (unfortunately, a field audit will sometimes be conducted simply for associating with a company involved in tax evasion or fraud, so it’s not possible to be completely safe, no matter how good your documentation is). During a field audit, IRS agents will visit your workplace, investigate your documentation, interview your employees, and more. If you are unfortunate enough to be selected for a field audit, you are going to want to retain the services of a tax attorney and prepare for a lengthy and invasive process.
Tips on Preparing for a Tax Audit
Whether you’re just sending in some documentation for a correspondence audit or preparing for a full field investigation, there are some steps you can take to make sure that you’re prepared ahead of time for whatever you’re going to have to deal with.
Keep Good Tax Records
The most important thing for you to do in preparation for a tax audit is to keep good records. You should do this anyway, but if you get in the habit of this early and have implemented good bookkeeping and accounting practices, you’ve done the most important part already.
Organize Your Information
This should follow naturally from your bookkeeping and accounting processes, but if you’ve been selected for an audit, you need to get the right forms and documentation in order. Collect all of the relevant financial data, especially anything that might affect your taxable income, and if you’ve lost or destroyed any records, make a concerted effort to reconstruct them, and document your attempts.
Account for Business Losses
One thing that often plagues startups and can draw attention from the IRS is reporting multiple years of business losses. If you are running a deficit in anticipation of future revenue, make sure that you can demonstrate that you have a path to profitability and you or your investors aren’t just writing off a hobby as a business expense or running an elaborate tax evasion scheme.
Be Smart About Deductions
These are easy mistakes to make, but make sure that you aren’t committing any common deduction errors: keep personal and businesses expenses separate, if you’re writing off travel or entertainment expenses, make sure you have the right documentation (including at least date, time, and amount), and rigorously document the business purpose of your write-offs.
Final IRS Tax Audit Advice
Like Benjamin Franklin said, the only sure thing in life are death and taxes, and audits are a part of that. It’s alarming for anyone to be the attention of the IRS, but the revenue service is just doing its job, and if your business is legitimate and keeping all of the right records, it will generally be little more than another bureaucratic hoop to jump through, and not a particularly difficult one.
When thinking about how to prepare for a tax audit, ask yourself whether or not you have adequate financial planning in place and if you’ve got the right people on your finance team to handle these sorts of challenges. Lean startups often overlook hiring the right financial experts, but having the right people is an investment in the future, and can make the difference between an audit being a disaster and one happening at all.