Preparing for a Business Audit

Be prepared for an audit of your business.

Who's afraid of the IRS? Almost everyone. The key to surviving a tax audit and even coming out on top is not to panic, but prepare.

What to Do Before Your Audit

If you go it alone, before meeting the auditor, you should thoroughly review the tax returns being audited. Be ready to explain how you, or your tax return preparer, came up with the figures. If you can't, then contact your tax preparer or another tax pro.

Find all records that substantiate your tax return. As discussed, the IRS has a right to look at any records used to prepare your tax return. Organize your records for the auditor in a logical fashion. Your pre-audit organization of receipts, checks, and other items will refresh your recollection for the audit meeting.

Neatness counts. Forget about dumping a pile of receipts before an auditor and telling him or her to go at it. Messy records mean more digging and more digging, to the IRS, means more gold for them. Conversely, auditors frequently reward good recordkeepers by giving these folks the benefit of the doubt if any problems arise. Neatness builds your credibility with the auditor. Tidiness and order appeal to an accountant's mentality, and most auditors are accountants.

Pinpoint problems backing up income sources or expense deductions. You'll need to be able to show your right to take tax deductions or other tax benefits claimed on your return. Research tax law, if necessary.

What to Bring to an Audit of Your Small Business

Audit success means documenting your expenses. Proof should be in writing, though auditors are allowed to accept oral explanations. A list of items the auditor wants to see usually accompanies your audit notice.

At a minimum, the IRS will expect you to produce the following documents:

Bank statements, canceled checks, and receipts. The auditor will want to see bank records from all of your accounts, both personal and business. As a rule, don't discard any business-related canceled checks, invoices, or sales slips. If you paid some expenses with cash, keep the paperwork (handwritten notes, notebooks, receipts, or petty cash vouchers) showing the payments.

Electronic records. Most banks don't return canceled checks anymore, and many business expenses are charged on credit or debit cards. Bank and charge card (Visa, MasterCard, American Express) statements are now accepted by the IRS as proof of payment. They must show the name, the date, the amount, and the address of the payee.

Because charges and statements don't always show the business nature of the expense, you can't rely on them as your only records.

Books and records. The auditor will ask to see your books. The tax code doesn't require small businesses to keep a formal set of books; don't let an auditor tell you otherwise. If you keep records with only a checkbook and cash register tapes, so be it. If you maintain more formal records such as ledgers and journals, the auditor is entitled to see them. If your data is on a computer, the auditor will want to see a printout.

Appointment books, logs, and diaries. Businesses that offer services typically track activities and expenses using calendars, business diaries, appointment books, and logs. An entry in a business diary helps justify an expense to an auditor as long as it appears to be reasonable.

Records for certain equipment. Additionally, you must keep special records for certain equipment, called listed property, that is often used for both business and personal purposes. (IRC § 280F.) Cell phones, computers kept at home but used for business, and vehicles used for both business and pleasure are designated as listed property.

Purely business equipment is not in this category. For example, mechanic's tools, a lathe, or a carpet loom are purely business tools, and no records of usage are required. But when assets are put to both business and personal use, the auditor can demand records of usage. For example, if you use a computer for business email and to play solitaire, keep track of the business portion. One way is to make notes in a notepad next to the computer.

If you haven't kept usage records of listed property, reconstruct them by memory or reference to projects that you worked on during the year.

Auto records. A vehicle can be listed property if it's used for personal purposes as well as business. So business use of your personal auto requires detailed records showing the work use portion. Here are some ways to do this:

• A log is the best way to keep track (and it's easy to keep a little notebook in the glove compartment), although it's not required by the tax code.
• Alternatively, you can keep all gas and repair receipts in an orderly fashion, with notations of trips showing how the car was used for business.
• A less accurate way to keep records is to add up the gas bills and divide by the number of miles per gallon that your car averages. Show the auditor your auto trip receipts and explain how they link up to sales trips by your business diary or calendar notations.

Travel and entertainment records. By law, out-of-town business travel and entertainment expenses (T & E, in auditor lingo) require greater recordkeeping than most other expenses. You must have a written record of the specific business purpose of the travel or entertainment expense, as well as a receipt for it. (IRC § 267.)

A good way to document T & E expenses is with an appointment book or log, noting each time you incur a business expense, and the reason. Most people aren't disciplined enough to write down every expense as it is incurred. It is okay to put together a log or diary after you have received an audit notice. But be up-front about it don't insult the auditor's intelligence by trying to pass off wet-inked paper as an old record. Remember, it's key to develop and maintain credibility with the auditor.

Expenses for renting or buying property. To prove business rental expenses, bring in a copy of your lease. If you purchased the property or equipment, have the purchase contract. This establishes grounds for claiming these expenses as well as a beginning tax basis of the property, if you claim depreciation expenses.

To learn more about small business tax audits, get Tax Savvy for Small Business , by attorney Frederick W. Steingold (Nolo). This book also provides the latest tax breaks, rules, forms and publications for small businesses, as well as a list of the top 25 business deductions and how to claim them.