There’s nothing more stressful than getting that audit letter in your mailbox. IRS audit is time-consuming and could be nerve-wrecking as well. Over my career, I’ve taken multiple business and individual clients through IRS audits with no adjustments made to books or tax returns. I’d like to share a few pointers from my own experience:
I got audited, but why me?
Almost all IRS agents told me the same thing: IRS has a complex algorithm that compares your tax return data with the “curve” or “pattern” they have in their system (information gathered from “big data”) and checks for reasonableness. However, I have noticed that you are more likely to get audited if you check one or more boxes from below:
Choppy trend: Hitting a great year, followed by a terrible one, and then hitting it out of the ballpark again - This won’t put you on the board 100% but certainly raises a red flag. Presenting a healthy and stable trend is generally recommended, unless there is genuinely an extraordinary event, for example, natural disasters, pandemics like COVID-19, etc.
Big top line but running a loss: Sounds suspicious already, right? Be prepared to have reasonable explanations and documentations in line to pass this one.
Making too much: Net income over $1mm is typically a good indicator that you’re “making too much money”. Simply put, IRS hopes there’s something in it for them to spend the time and resources on an audit. It’s just more likely for them to get something out of it if they know you have the $$$.
What do auditors look for?
Process walkthrough - IRS agents ask a lot of questions, which can be intimidating. What they’re trying to do here is to understand your business process - how do you get new customers? How does a lead become cash in your bank? Based on what you said, is it possible for you to miss or under-report your income? These are all important assessments being made in this part of the audit.
Bank activities - Does your income match all the deposits? Did all the activities foot? Was there commingling of funds between business and personal? I always advise my clients - if you don’t want IRS to open additional audits based on results from one initial audit, keep your business and personal expenses separate, and always keep a clean paper trail.
Major spendings - Be prepared to present documentation for major spendings and provide comments. My clients always ask me: if I don’t have the receipts, does it mean IRS won’t let me take the deduction whatsoever? The answer is, it depends. For example, if you didn’t have the receipts for $30 charged by Uber, but you have documented on your credit card statement, that this is the trip when you went to LA for a conference, accompanied with conference related plane tickets and lodging details, there’s a good chance the IRS will allow it. However, you don’t want to push the rules - we all know that Nintendo you bought serves no purpose in your jewelry crafting business.
Contractor payments - Definitely a big area. IRS agents typically ask for agreements with specific service terms, work reports and related documentation to help determine the legitimacy and compliance of the contractor payments. Were W9 and/or W8-BEN collected? Were Forms 1099 filed?
Sample tests - If your business is on the larger scale, instead of going through all transactions, it is not uncommon for the IRS agent to sample a few transactions deemed significant or representative to form an opinion on overall financial integrity. For example, they may ask you to provide PO records from key customers, POD (proof of delivery) if you sell goods, etc.
When in need, get in touch with us to consult on your situation. At Zhong & Sanchez, we provide One-Stop-Shop Tax, Finance, Accounting and HR services for Startups and Entrepreneurs. We do it all, so you can stay focused on your business. Our experience in tax and accounting will free you from back office work; our extensive knowledge with start-ups will help you grow in the most efficient way. Located in the Silicon Valley, you can reach us at 510-606-6971 or schedule your first consultation today at https://calendly.com/zhongsanchez