How IRS Audits Work [Updated for 2021]

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How IRS Audits Work [Updated for 2021]

IRS audits are fraught with mystery.

Yet, IRS audits generally unfold in a routine manner. It is worth taking time to remove the mystery so people know what to expect and how to deal with it.

The reaction that we see among clients in our Atlanta, Georgia accounting firm is nearly universal:  The clients receive a letter in the mail from the IRS telling them that their tax returns have been selected for audit.  Shock ensues.  Then panic.

We calm them down and then we start to prepare for the audit.

Preparation for the Audit

Preparation for IRS audits includes gathering three years of tax returns – the return under audit and the returns for the preceding two years.  Give them to your CPA.

The CPA will review the return to identify red flags that may have triggered the audit.  These are likely going to be the focus of the IRS auditor.  Here are some examples:

  1. Multiple years of losses from a business
  2. Taxable income that a person could not live on
  3. Expensive lifestyle than does not match the income reported on the return
  4. Businesses that use contractors, rather than employees
  5. Significant meal expenses
  6. Missing income from W-2’s or 1099’s
  7. Excessive charitable donations, including gifts of non-cash items to Goodwill and other organizations
  8. Excessive auto mileage
  9. Operating a cash based-business
  10. Using numbers that look like estimates
  11. S corporations without officer compensation

Keep in mind that auditors are instructed to review Google and social media for taxpayers who they are auditing.  They will be looking for evidence of expensive trips or a lifestyle inconsistent with the tax returns.

Cash-Based Businesses

Cash-based businesses are a particular focus of IRS audits.  According to the IRS, “cash transactions are anonymous, leaving no trail to connect the purchaser to the seller, which may lead some individuals to believe that cash receipts can be unreported and escape detection.”  Therefore, businesses that are paid in cash need to be extra careful to maintain receipts and accounting records which the IRS will ask for in the event of an audit.

In particular, the IRS is looking for skimming cash from sales, stolen cash, stolen goods later used for resale, and fraudulent disbursements.

Examples of cash-based business which are on the IRS radar include bail bond companies, beauty shops, car washes, coin operating amusements, convenience stores, mini-marts, bodegas, laundromats, scrap metal businesses and taxicabs.  The IRS is also devoting audit resources to the “underground economy,” which includes used car sales, child care, house cleaning, pet sitting, tree trimming, hauling and construction.

It is also worth mentioning that state departments of revenue are also aggressively auditing cash-based businesses for under-reported revenue on sales tax returns.  If the state catches you, they will happily share the information with the IRS.

Power of Attorney

Your CPA should ask you to sign a Power of Attorney, Form 2848.  This allows the CPA to speak with the IRS on your behalf.  There is nothing scary about the Power of Attorney.  It only applies to IRS matters and nothing else.

A separate Power of Attorney should be prepared for the the taxpayer, the spouse of the taxpayer, and each business.

Gathering Documents

Next, your CPA should ask you for supporting documentation for every number on your tax return.  Do this even if the auditor only questions some of the items on the returns.  Nothing will stop the audit faster than a taxpayer who is prepared with everything.   In addition, some audits start small and later expand in scope.

A good place to start is with third party documentation.  Be sure that the income reported on your tax returns agrees with W-2’s and 1099’s.  Deposits on the bank statements should match reported income unless you can explain why not.  Same with the Point of Sale (POS) records.

You will need receipts for charitable contributions, medical expenses and other deductible items, which are frequently the subject of audits.

If you had stock sales, get copies of the brokerage reports.  If you sold a home, get copies of purchase and sale documents, as well as proof of improvements made to the home over the years.

Do you have foreign accounts?  If so, the auditor will want to know if interest and dividend income from those accounts is consistent with income reported on the tax returns.

In the case of a business, confirm that gross receipts on the sales tax returns match total sales on the income tax returns.   This is one of the first things that an auditor will ask to see.

In addition, you will need the receipts for businesses and rental properties.  For example, you will need to provide your accounting records, including an Income Statement, Balance Sheet, and Trial Balance. The auditor will be checking for accounting irregularities, including unreconciled bank accounts. The auditor will also be looking to see if the expenses of the business are consistent with industry norms.

In short, you want to assemble back up for everything.  If you need more time to gather information, your CPA can request an extension of time to respond.  Auditors generally agree to this, especially if you show you want to cooperate.

Missing Documentation

If receipts are missing, check to see if you can get a copy from a third party.  For example, charitable organizations may be able to give you a proof of donations.  If donations were paid by check or credit card, it may be possible to get proof from the bank.

If the 1099’s and W-2’s are missing, get copies of the IRS transcripts.  Your CPA should be able to help you with this.

When it is impossible to find receipts to support the deductions on your tax return, your CPA may be able to reconstruct records. This IRS will often accept reconstructions, at least for some expenses, provided that the reconstruction method utilized is reasonable.

Be Careful What You Say

The taxpayer should generally not speak with the auditor. Let the CPA handle communications and negotiate on your behalf.  That is what the Power of Attorney is for.

Also, the taxpayer should never comment on the audit on Twitter, Facebook or anywhere else on social media.  Be careful what you say and keep your nose clean.

Audit-Proof Your Tax Return

The best way to audit-proof a tax return is to adopt a cloud-based system for storing and organizing receipts.  We have written about Dropbox in a separate article.  QuickBooks Online has a receipt capture feature that does this as well.  Expensify is another popular option.

Whichever system you use, the ability to easily put your fingers on receipts for your expenses will generally help to resolve IRS audits in your favor.

In addition, if you have a business, it is a huge help if you can show the IRS that you have been using an accounting software to keep track of your books.  Make sure that your CPA or bookkeeper reconciles your books each month.  This goes a long way to prove that your numbers are right and it will make you look much better in the eyes of the IRS auditor.  We use QuickBooks Online, Xero and Bench in our Atlanta, Georgia accounting firm.  Call our office to discuss which platform is best for your needs.

Challenging the Audit

If you are in the unfortunate position of owing money to the IRS as the result of an audit, you may request audit reconsideration.

Under this process, the taxpayer (or their CPA) provides documentation to the IRS explaining the audit adjustments that they disagree with, along with supporting evidence.  It is important that the taxpayer provide new information.  If it is the same information that the taxpayer previously provided, the request for reconsideration will be denied.  The taxpayer does, however, still have a right to go to Appeals.

By Gary Massey, CPA

Founded by Gary Massey, Massey and Company is a boutique CPA firm is located in Atlanta, Georgia serving the needs of small businesses and their owners.  We assist clients throughout Georgia with taxpayer representation for IRS audits.  We also provide tax preparation and tax planning services, as well as accounting and bookkeeping services for businesses.

Massey and Company CPA

Based in Atlanta and Chicago, Massey and Company CPA specializes in tax and accounting matters of small businesses, entrepreneurs, and their families.
We do everything related to tax return preparation and tax planning, as well as accounting and bookkeeping for small businesses using QuickBooks Online.
In addition, we represent taxpayers before the IRS, keeping taxpayers out of tax trouble. We negotiate with the IRS and the state, so you do not have to.
We know the tax issues. We know our way around the IRS. We know QuickBooks. And we know how to help you save taxes and keep more of your hard-earned profits.

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