We stand ready to assist you if your return is selected to be examined by the IRS. Here are some things you need to know.
HOW TO SURVIVE AN IRS EXAMINATION
The IRS is stepping up its audit of individual and business tax returns. There are three basic IRS examinations:
1. Letter notification – The IRS sends you a letter noting some items on your return that cannot be located or are missing. You will respond by letter. In most cases, these notices can be resolved quickly.
2. Office notification – The IRS sends you a letter notifying that it is conducting an office examination of your return. They will set a time for your appointment at their IRS office. You will be notified of the documents and areas of concern that they have. Usually there are one to three issues in particular that they are examining.
3. Examination notification – The IRS sends you a letter notifying you that your return(s) are under examination. They will set a time and place for the examination. The IRS prefers to conduct the examination at your place of business but may agree to move it to our office. The IRS will make a formal information document request. It can cover every item on your return.
Regardless of the type of examination, you should inform us immediately about any IRS correspondence. In many cases, we can handle everything for you and your involvement is very limited. In other cases, you will have to spend some time collecting and summarizing data the IRS wishes to see. In all cases, do not panic. This is a normal activity of the IRS. If you have been in business for any length of time, there is a good likelihood that you have experienced one of these three IRS exams.
Experience has taught us that major issues that present problems in an IRS examination are lack of documentation and sloppy records. A good general ledger set of books can go a long way in shortening the IRS audit. There are excellent general ledger software programs that are relatively inexpensive, like QuickBooks and Peachtree. Having all of your transactions captured in a general ledger format is a plus. In the absence of general ledger software, you can use Excel spreadsheets or a very detailed checkbook.
We can provide financial accounting services that will give you an excellent audit trail and provide you with up-to-date financial reports. While we cannot prevent you from being audited by the IRS, we can provide an audit trail and streamline the process. You should seriously consider this option if you do not have the time or expertise to maintain a set of books.
WHAT ARE VALID SUPPORTING DOCUMENTS?
Here are documents that you should be able to provide for each expense:
1. Invoice or receipt
2. Canceled check or image, or debit card notation on bank statement
3. Credit card statement (but the statement alone is not sufficient, you must have the underlying invoices)
4. Contract agreements (for rent or other contractual services)
For certain expenses and expenditures, you need more than the documentation listed above.
1. Mileage – You need to provide a contemporaneous (at the time incurred) mileage log that lists the distance, client, and purpose. For example, an entry might read: 23 miles round trip to Joe Client to discuss job bid. Even if you are using actual expenses for your vehicle, the mileage log is required to establish percentage of business use. You need to record the beginning and ending odometer miles at the beginning and end of your fiscal year.
2. Entertainment – In addition to the credit card receipt, invoice and credit card statement, you need to indicate the date, amount, who was there and what business was discussed. Many credit card receipts have a place for this on the back of the receipt. If not, write it on the receipt or reference it in an entertainment log. Even if you have the receipts but cannot establish the business connection, your expense may be denied.
3. Travel – Again, as in Entertainment, you must establish the business purpose of the trip.
4. Owner fringe benefits – Treatment of owner fringe benefits depends upon the entity (corporation, LLC, sole proprietor) and the type of benefit (health insurance, disability insurance, long-term care, life insurance, company car, etc). Be sure that you make us aware of every type of fringe benefit that you have.
5. Owner loans to and from entity – At least by the end of the year, you should formalize any loans between you and your company. You need to have a valid, enforceable promissory note with a stated interest rate. Ultimately, you must repay any loans the company has made to you or report the amount as income. Without a note, you run the risk of the IRS treating the amount as compensation or a constructive dividend.
6. Business gifts – You are limited to $25 per individual per year. Some items are not subject to the $25 annual limit – items costing $4 or less with taxpayer imprint; signs and promotional materials; incidental costs such as shipping, gift wrap or engraving; and awards of tangible personal property costing $400 or less given to an employee.
7. Charitable donations – In addition to the canceled check or image, you need an acknowledgment from the charity if the donation is $250 or more. The acknowledgment must be received by the earlier of the date the return is filed or the extended due date for filing, including extensions.
Here are some other helpful hints to guide you through the IRS examination.
1. Answer every question truthfully but do not volunteer information not requested. IRS agents are trained to listen. Give them what they ask for but do not give them more without consulting with us first.
2. Be sure your bank statements are reconciled to your books. A typical IRS audit procedure is to reconcile deposits on the bank statements to your revenue. If you make a deposit that is not revenue (ie, loan proceeds, expense reimbursements, error corrections), be sure to notate on the statement what that item represents. This is much easier to do on a monthly basis than three years after the fact when you are being audited.
3. Any record requested by the IRS agent should be pulled from your files by you – not the agent. Do not give them access to all your files. Request that you handle any copies they want to make.
4. Record and report all revenue. All revenue should be reflected in your bank account – cash, checks, charge cards, etc. Do not pocket cash and fail to record on the books. Even if an honest mistake, your credibility is at issue.
5. Take a deep breath. The IRS is going to put the worst slant on a contested item. You will have your chance to make your case with the IRS. Do not become belligerent or confrontational. In every instance, you can say, “I need to consult with my tax advisor. Let me get back to you.” The agents expect this and will have no problem letting us discuss the issue.
6. Corporate stock/minutes. If you are incorporated, you need to have a stock and/or minute book that records major decisions of the corporation like shareholder compensation, loans to and from shareholders, acquisitions and disposals.
HOW LONG DO I NEED TO KEEP MY RECORDS?
Our safe harbor recommendation is that you keep all your detailed records (invoices, checks, bank statements, books) for seven years from the date of filing. The IRS in almost all cases will not go back more than three years and in most cases only two. However, you never know what issues may arise that go back further than three years.
Some records need to be kept indefinitely – rental contracts over seven years, basis information for underlying assets still on the books, tax returns. All records with continuing relevance should be retained.
You can get more precise information at Records Retention Guide
We hope this brief discussion of IRS examinations and the books and records you need to keep are helpful. If you have recorded all your revenue and have appropriate documentation for all your expenditures, you should feel confident that you have given yourself the best chance to survive an IRS examination.
