Have you received an IRS notice that your tax returns are being audited? What should you expect?

An IRS audit can be a nerve-wracking experience. The IRS audit process is fairly simple when you boil it down to what the IRS is looking for. Here’s what the IRS will ask for in an audit of a business tax return, and how you can prepare for an audit before you even get selected.

INCOME: The IRS will audit the income reported on your business income tax return. They will request bank statements for the period under audit and perform a very simple test of your sales number. They merely add up the deposits made to your bank account and compare that number to the sales amount reported on your return. If the amount deposited to your bank account is higher than what you report, you will be asked to explain the difference. If the difference can’t be explained, the IRS will adjust your income by the amount of the difference.

So, what causes the differences? The biggest cause of your bank deposits being higher than your reported sales is loans made to the company. These can be loans from your bank, a line of credit, or loans from shareholders or relatives. If this is the case, you simply need to show evidence of the loans and why they should not be counted as income. If the deposits are from a bank line of credit, you can help the IRS trace the deposit to the corresponding loan statement. If the loan is from you, as an owner, or from other shareholders, the deposit should be evidenced by a copy of the check, and a promissory note.  If you make loans to the business from yourself or from friends and relatives, make it a practice to take a copy of the check and execute a promissory note evidencing the indebtedness.

EXPENSES: Proving your expenses is what gets many businesses in trouble due to poor recordkeeping.  The IRS will typically ask for a general ledger from your accounting software to show the detail behind the expense lines on your tax return. They will randomly select certain expenses and ask for two things: an invoice showing what was paid for, and proof of payment such as a cancelled check or credit card statement. Caution: a credit card statement or bank statement is not proof enough! You must have both the proof of payment and invoice showing what was purchased. Otherwise the IRS will disallow the expense!

The banks have done consumers and businesses a great disservice in recent years by stopping the practice of providing their customers copies of cancelled checks. You must have this proof in the event of an IRS audit. Normally all you need to do is call your bank and request that imaged copies of all cancelled checks be provided with your bank statements. You may have to pay a few dollars to turn this feature on, but if you are running a business, this is a must have. And don’t be fooled by thinking “my check images are online so I can download them if needed”. Number 1, banks merge and change systems frequently leaving customers out in the cold unable to access their history after the merger. Number 2, you may decide to change banks, leaving behind all your history once you close the old bank account. Number 3, many banks keep images for only a certain period of time. The IRS has 3 years to audit your books, a time period usually longer than what your bank keeps for online history.

This is just a summary of what the IRS will look for in an audit; an actual IRS audit can involve much more than this. Our advice is to always seek the professional services of a CPA or Enrolled Agent to represent you before the IRS if you get selected for an audit. And be sure to understand how an audit works to improve your small business recordkeeping.