OK, the IRS auditors aren't as bad as the tattooed, green haired punk trying to take your daughter out on a date. But, if you are a small business owner, it can be just as threatening to your business financial health.
First and foremost, the IRS is back and in a BIG way. In the seventies and eighties the IRS in El Paso was very active and there was a very decent chance that a small business owner would experience an audit, especially as their business sales increased. Starting in 1995, there were senate hearings on abuse of power by the IRS. The end result was budget cuts for the IRS and a reduction in the number of audits nationwide, including the El Paso area. For example, none of the tax returns I prepared had been chosen for an audit between1991 to 2006. This would have never happened before! In the last two years, three of my returns have been audited. In two of these cases, I warned my clients that their tax return had red flags for an audit, but unfortunately they did not believe one would happen. And from what I have seen and heard, more audits are to come.
The best analogy for what is happening is a busy intersection where the speed limit is 25 MPH. No one drives that slow but, all of a sudden there is a speed trap on that street for a week straight. The law hasn't changed – only the enforcement. That is what is happening with the IRS. Business owners were always supposed to have the proper documentation for all expenses deducted on their return but few ever did!
If you are a business owner you are definitely a target! The IRS believes that:
1. You are hiding income.
2. There are taxes to be collected from you.
3. You don't have the necessary documentation to back up claimed deductions- in most cases they are right.
Another big change with the current audit process is that the new IRS auditors are sticking to the letter of the law. To put it simply – if it isn't written down it didn't happen! The older auditors in the 70's an 80's were more willing to negotiate a reasonable amount if your records were not complete. The new auditors are making a decision to throw out any deduction not fully backed up. They know that you have the right to take them to tax court. And, they know that you have a much better chance to win there if you can show adequate evidence that you had the deduction. But, they also know that it will cost you $5,000 to $10,000 to hire a tax attorney and they are betting that many taxpayers will just decide to pay the tax to end the suffering. It’s like an expensive game of chicken.
Do not underestimate the financial risk of an audit to your business! Almost 80% of audits result in the IRS assessing more taxes with penalties and interest. Not to mention the cost of representation!
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A common misconception is that your tax preparer will represent you for free. Sorry, don’t take it personal; but, all I sell is my time, knowledge and experience. When you hire us to prepare your tax return we, are preparing your taxes from the information you provide us. But, we are not auditing it to determine that you have proper documentation as required by the IRS. This is true of all tax preparers nationwide.
The time lost to prepare for an IRS audit is another cost to the business owner. This is time that could and should have been used to get new customers or improve your business operations.
So, how can a business owner defend themselves? The only defense is to accept that an audit is a real risk. Learn what documentation you need and develop systems to gather the information needed, not only to survive an audit, but to make the process run as fast and smoothly as possible. Future posts in this series will provide you with the information you need to accomplish this.