As the owner or operator of any small business, an IRS audit may be the most trying and least rewarding experiences you can undergo. However, with a clear understanding of what could happen, some planning, and good preparation, you can decrease the pain and increase the odds of successful outcome.

Here at Yellis & Foley, we've assisted clients with Maine sales tax and other state audits, as well as federal tax audits. Additionally, Mark & Jim both worked on corporate audits while with Hannaford Bros. Based on our experience, we think the following tips can help you confront this potential challenge. (Of course, as accountants, we will always maintain that strong record-keeping is important.)

What the IRS Wants

IRS auditors want to ensure you've correctly stated your income and paid the tax you owe on that income. Thus they scrutinize your entire business to find out the reality of your income and expenses.

Unreported, or underreported, income: One of the biggest finds for an auditor is additional income, because it almost always results in additional taxes, plus penalties and interest. They tax and impose interest and penalties on unreported income whether the mistake was accidental or intentional. Significant fraud can result in criminal charges.

Expenses: Auditors also will monitor whether you've accurately separated personal from business expenses. They pay attention to entertainment, travel, meal, and transportation expenses in particular, expecting you to prove that each expense directly connects with your business. They also will want a mileage log for any car that has personal and business uses.

Employees vs. Independent Contractors: Just because you think someone is a contractor does not mean the IRS will. Auditors look for extra employees to assess additional payroll taxes, interest, and penalties. Real contractors have businesses of their own and offer services to other customers. If you are telling people where, when, and how to work, the IRS may consider these people employees.

Planning for Audits

We encourage these business practices whether you're facing an audit or not: they make your business efficient and will help you face any scrutiny.

Simplicity: Keep your business practices straightforward. Find the simplest and easiest way to accomplish your financial goals. The more complex and confusing your financial practices are, the more room there is for error.

Record-keeping: Keeping track of what happens in a consistent and clear manner as you go is a lot easier than trying to figure out what happened when facing an auditor. Implementing solid accounting software and procedures now helps you measure the success of your business and allows you to make decisions with solid information.

What to keep: Auditors may ask for many kinds of records. It's a good idea to keep: receipts for expenses, invoices for income, bank statements, cancelled checks, accounting ledgers, computer printouts of the data you used to file tax returns, leases and titles for business property. In most cases, clear digital scans of original documents will suffice. Some accounting software allows you to organize and store scanned images with the digital records they support. The key here is to keep your documents in an organized and consistent system, so that your 'paper trail' clearly matches your activities.

Preparing for Audits

If you have well-kept records, preparing for an audit should be easy. Pulling the appropriate files and records from huge, disorganized pile increases your chance of missing something. You should present the auditor with a neat, logically arranged set of documents that clearly aligns with your explanation of your business practices.

Another way to prepare is to engage a tax professional (CPA). People like us are used to audits and can help ensure that you have appropriate records. We keep abreast of tax laws and changes--helping you to know what you are required to do. Allowing a CPA to speak on your behalf lowers the emotional tone of some audits and ensures that you offer the right information in the proper manner.

You can read and download the IRS Auditor Guides for certain industries at irs.gov. Their MSSP (Market Segment Specialization Program) trains auditors to find typical tax evasion strategies in specific industries. Understanding how auditors are trained can be a good strategy for preparing for their questions. Anticipating their inquiries will allow you to ensure you have the relevant documentation available.

Surviving an Audit

The best thing you can do to avoid disastrous audits is to ensure you are in compliance with tax laws as you go. No audit strategy can fully cover a business that routinely violates the law. After ensuring you follow the law, good record-keeping is the most important tool in undergoing an audit.