Running Your Business

3 Audit Preparation Steps for Small Businesses

  • Approximately 2.5 percent of small businesses in the U.S. get audited by the IRS each year

  • Preparing for a potential IRS audit can make the process a lot less complicated and stressful

  • Small business owners can maintain accurate records by using accounting software

Posted by February 26, 2020

Tax season signals a time for small businesses to think about audit preparation. While a small percentage of businesses actually get audited each year, it is a good business practice to understand how to respond to an audit.

According to the 2017 IRS Data Book, audit rates have declined since the budget for auditors was reduced in the last few years and the IRS has lost nearly 15 percent of its previous workforce. It’s estimated that the IRS audits 2.5 percent of small businesses each year, the Houston Chronicle notes.

However, the IRS still carefully scrutinizes the tax returns for small businesses at nearly twice the rate of individual tax returns. Accordingly, small businesses should always be ready with a structured audit preparation plan.

Getting Ready for an IRS Audit

The necessary steps for audit preparation are fairly simple to complete. Here are three things you can do to get started.

1. Organize Your Documents

The largest task of audit preparation involves accurate record keeping as a small business owner. This can be facilitated by the use of financial software that tracks and stores business records. It’s recommended that organizations retain the following records for at least seven years of past tax returns (but just start with the most recent tax years, for now):

  • Income generated by the business: Invoices paid by customers; cash, check and credit card sales; profits for sell-off or trade of inventory or wholesale goods or services.
  • Business expenses of all kinds: Inventory, sales aids, payroll for employees and/or contractors, office supplies, equipment, vehicle and transportation costs, health insurance premiums and taxes paid, utilities and building overhead costs, travel receipts, fees for writing off expenses and tax filings, mileage records and more.
  • Financial records: Bank statements, receipts, canceled checks, accounting ledgers, records of services (justifying business expenses such as materials, billable time, entertainment and travel) and business credit card statements.
  • Legal documents: Court records relating to the business; any liens, settlements, stock sales and shareholder reports; documents showing transfer of ownership, loans, contracts, employment agreements, etc.

2. Pre-Audit Meeting With Your Accountant

If you are unsure of what records you have, or are missing proof of any of the business financial reports above, it’s a good time to get help. Set up a meeting with your business accountant and review your taxes as part of your audit preparation.

By doing this now, you will have a better chance of a smooth IRS audit (and proof that you’ve done your due diligence as a business owner). Make this an annual process when the tax season slows down.

3. Create a Plan for Business Operations

During an IRS audit, you may be asked to spend anywhere from a few days to a few weeks completing the process. A lot of this can be done via mail. Rarely, an auditor will actually visit a small business or require the business owner to meet at an IRS field office in person to complete the audit.

As a business owner, it’s critical to provide instructions for your next-in-charge staff to keep the business at full operation while you are called away. It’s also important to have a detailed plan for how employees are to respond to IRS inquiries—which should all be directed to you and your accountant immediately.

While it may seem frightening to receive notification that the IRS is auditing your business, it’s best not to panic. Frank Pohl, an attorney at Gunster law firm, shared with Business News Daily that not all IRS tax audits end badly for taxpayers. It’s best to read the IRS audit letter carefully and provide only the records and information requested for the specific tax year. Do not overcomplicate things and be as accommodating as possible to the auditor. There are some cases when the IRS will allow extra time to provide documentation or may accept alternative proof of business financials.

You can work with your accountant to prevent being red-flagged by the IRS in the first place. But, it always helps to be prepared.

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