Vince Lombardi, when he coached the Green Bay Packers football team, was quoted as saying that “The best defense is a good offense”. If you are being audited by the IRS, you need a good offense to defend your business against IRS assessments. Just as a good coach prepares in advance for the big game, the business likewise must prepare in advance of the scheduled audit exam.
All coaches use a playbook to prepare for the big game. Thus, you need to know the opposing team’s (the IRS) playbook. The IRS’s playbook consists of the Internal Revenue Manual (IRM) and the Audit Technique Guide (ATG). The ATG is particularly insightful as it summarizes for the auditor the important issues relating to certain businesses that the IRS has designated as having the greatest potential for audit adjustments. The ATG lays out a roadmap for the auditor as to what issues are of concern to the IRS, the questions that need to be asked of the business owner, and the IRS’s audit techniques. An experienced tax professional will review the ATG well in advance of the scheduled audit date (which usually can be delayed for reasonable cause) and work with the business owner to put the business in the best position to substantiate its business deductions.
What other steps should be taken in advance of an IRS audit? The business’s tax returns need to be reviewed to look at the description of expenses on the return, identify and discuss any expense items that are significantly greater than the industry average or amounts shown on prior years’ returns, discuss items that were expensed that the IRS may argue should have been capitalized, identify if the proper tax elections were made, and review any disclosures made on the return. While all of these should have been done as part of the tax professional’s preparation process, it is a good idea to review them again. Remember that the IRS has a major advantage that the taxpayer did not have when the return was prepared, and that is 20-20 hindsight.
Since the IRS is concerned about businesses reporting all of their cash receipts as income, a reconciliation analysis of the company’s gross revenues reported on the tax return to the company’s bank deposits should be done. Why? Because this is a standard IRS audit step. You want to identify any discrepancies and be able to explain these differences to the auditor. If you cannot explain the differences, the IRS will assume that the differences are underreported income. Often these differences are timing differences, income recognized in one period per the books and in another period per the bank deposits (i.e., deposits in transit). Another reason for discrepancies is transfers between a company’s checking account, savings account, and payroll account. If the company is depositing revenues in a checking account and transferring those monies to a savings account and then to a payroll account, you want to make sure that you pay taxes only on the sales receipts and not the bank account transfers.
A review of the company’s accounting records should be done to make sure that those records agree with the tax returns filed. If you are not requesting year end journal entries from your tax preparer, you need to do so! If the accounting records do not agree to the tax returns, appropriate entries should be made to identify and correct those discrepancies. Remember that the IRS has trained its auditors to be proficient with QuickBooks, Sage, Peachtree, and other software programs. These programs are often the starting point for IRS agents.
While the steps discussed above on how to prepare for an IRS audit are not all-inclusive, hopefully it gives the business owner a better perspective of how audits by any tax jurisdiction should be handled and why it is usually in the business owner’s best interest to engage an experience tax professional to handle the audit exam.
Our next blog posting will discuss possibly the most important factor that can affect the outcome of your audit exam.
We invite you to call 610-594-2601 today to make an appointment to discuss your audit exposure. You can also schedule a free consultation at Click Here.
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