On average, 1% of all taxpayers or over 1 million Americans will face an audit. The more income you earn, the higher your likelihood of receiving that unwanted inquiry from the IRS.
So what are the odds of hearing from the IRS? Individuals making between $200,000 and $1,000,000 have a 3.2% chance of being audited. Compare this with the 17.2% audit rate of those who rake in over $10,000,000 per year.
While the thought of having the IRS storm your castle may send shivers down your spine, there are preparatory steps you can take to ensure that your audit experience is as smooth and painless as possible.
- For starters, don’t panic. It’s common for the IRS to request additional information to clarify any questions they may have. IRS agents may ask you to come to their office, or they’ll request to visit your office to examine the physical location of your business. Either way, as soon as you can, get organized.
- Organize and digitize. The single most important step in preparing for an audit is to get all of your bookkeeping in order. Make sure you properly accounted for all the income you earned in the past fiscal year because it is all too common for independent contractors and small business owners to miscalculate revenue. Adding up all those 1099’s can make you cross-eyed, but reporting less than what’s documented under your social security or tax ID number could trigger an audit.
Your auditor will be looking for issues like inconsistent reporting — i.e., declaring income on the basis of cash and on the basis of accrual, rather than sticking with one form of accounting on all documents. For example, people in the service industry report income on a cash basis, which means earnings are recorded only when money is received and expenses are documented only when money is actually paid out. Whereas an accrual basis — where you record revenue and expenses before cash goes in or out — is a more accurate way to gauge the financial health of your business. The IRS prefers to see the most accurate representation of revenue and expenses as they are incurred.
A shoebox full of expense receipts is simply unacceptable in this digital age, so digitize your records for better organization. Digital formats allow you to manage your finances more efficiently and accurately, including a quick way to search your files. Additional organization priorities include keeping expenses categorized and closing your books monthly to better identify possibly discrepancies. One more upside to going virtual: In the event of a natural disaster, you won’t lose that paper trail the government will expect you to have.
- Maintain accurate employee documentation. Another important aspect to consider in anticipation of an audit is employee records. We’re talking W-2’s, I-9’s, and other personnel files. From managing paid time off to double-checking invoices, business owners must ensure payroll accuracy to avoid suspicious red flags for the IRS. Keep salary information and pay history easily accessible, and make sure to keep track of the amount of taxes your business pays on behalf of your staff.
- Play by the rules. After going through and optimizing organization of your bookkeeping, go back through all your records and double-check everything. Reevaluate statements, confirm accuracy across all digital and paper documents, and identify any finances that may have slipped through the cracks initially. Getting audited doesn’t necessarily mean your company is going to get hit with any big fines. With so many businesses violating tax requirements, the IRS often just wants to ensure that everyone is playing by the rules and staying compliant. (As of March 2013, the IRS found 222,821 tax returns totaling $1.86 billion in fraudulent refunds!) Being able to present the IRS with well-organized, clean bookkeeping maximizes your chances of coming out of the audit unscathed.
- Get some help. In many cases, it’s more important to focus on your core business than to try and master non-core tasks such as accounting, taxes, and staying audit-ready. Using software is certainly one proven way to go. If you didn’t want to spend time on data entry however, offloading these tasks to services-based businesses will greatly raise the efficiency of running your business.