Audit-Proof Your Business
Audit-proofing your business requires dedication to the financial paperwork. To have the best outcome for an audit requires a commitment to regularly staying caught up and understanding your tax obligations.
Lagging on the paperwork and disorganization gets business owners in trouble. When business owners take shortcuts or avoid doing paperwork, the mistakes can become a big burden later on.
The best practice to audit-proof your business starts with a knowledgeable accountant and a CPA. Accountants take care of the day-to-day accounting. The CPA is a business partner that will assist your company in staying compliant with tax laws and guide your business planning and growth. Both an accountant and a CPA are very important for audit-proofing your business.
Types of Audits
Internal audits are performed within the company and may be referred to as a self-audit. A self-audit can be performed at any time during the year. The end of the year is particularly important to discover transactions that may be coded incorrectly or were mistakenly entered into the wrong account. An internal audit assures every account is reconciled before preparing the tax return. It also helps to assure that all documentation is collected to complete the tax return.
External Audits assure owners that internal processes are following Generally Accepted Accounting Procedures (GAAP) and industry standards. GAAP principles apply consistent standards to procedures to comply with established rules and regulations.
An external audit helps to identify areas to improve internal controls and regulatory compliance. External audits lend impartial credibility to the accuracy of financial records.
Normal preparation of financial statements by a CPA will not include assurance. The financial statements will not include a formal report to verify the accuracy or completeness of the statements. Financial reports without assurance are intended for the companies internal use.
- Assurance is obtained by obtaining evidence
- Highest level of assurance is an audit
- Level of assurance needed for financing depends on loan size, collateral, and overall risk
- Compiled statements are not audited or certified
- The compilation report includes a letter from the CPA to make the CPA’s role more apparent
- If the CPA is not independent, the CPA must disclose the lack of independence
- Assures financial reports have been prepared following the financial reporting framework
- Used by lenders for financing small amounts
- Performed by an independent CPA
- For higher levels of financing
- Provides limited assurance
- Performed by an independent CPA
- CPA performs verification and substantiation procedures
- Highest level of assurance
A tax return may be selected randomly for an audit or an audit may result because of a “red flag.”
Each year a certain number of returns are randomly chosen to be audited; they are selected by “luck of the draw.”
The IRS uses formulas that compare your return against other returns. The formula looks for normal ranges. If a deduction is not within a range for your business industry and size, the return will be flagged for a manual review.
Reasons your return may be flagged:
- Missing or mismatched paperwork
- Calculation and data entry errors
- Rounded numbers
- Low income with high deductions
- Claiming losses several years in a row
Your return may also be selected because of an audit of another taxpayer’s return if there are transactions connected to your tax return.
The IRS looks for inconsistencies by linking payer records with the recipient records through 1099s. To audit-proof your business, always report all income.
Audit by Letter
IRS letters are sent out about 6 months after the tax returns are filed. The IRS mails the audit letter. They never communicate by email or through a phone call. If you question the legitimacy of an IRS letter, contact a tax preparer or a local IRS office to verify that is authentic. The IRS will send a letter that will have a notice number beginning with CP or a letter-number beginning with LTR located on the top or bottom right-hand corner. You can also contact the IRS at 1-800-829-1040.
Types of IRS Audits
The IRS has three general types of audits:
- Adjustment letters that are sent for miscalculations
- Correspondence audit that will request additional documentation
- Examination audit that looks closer at records
A CP2000 notice isn’t an audit; however, the process is the same. A CP2000 notice is used to inquire about underreported income. The IRS has information showing that you haven’t reported all income on your tax return. Often, it’s for a 1099-NEC, if you are self-employed.
Responding to IRS Audit Notices
IRS notices require a quick response. Don’t ignore IRS notices, respond promptly.
If the notice is correct and you agree, then make the payment or payment arrangements quickly to avoid interest and penalties.
If you do not agree , the notice should be discussed with your CPA to determine how to respond or to determine if representation is needed. Documentation or a letter of explanation may clear up the issue if the evidence is provided to support your figures.
Always send the IRS copies, never send original documents.
- Field audits take place at the taxpayer’s home, place of business, or accountant’s office
- In-Office audits take place at an IRS office
Prepare for the audit. Cooperate with the auditor and provide everything the audit correspondence asks for.
Have documents readily accessible. Neatness helps convince auditors that you are attempting to keep organized and accurate records.
Organize records in a logical order. Keep receipts flat and by date. Paper clip small receipts together to keep from losing. Organize checks by check number and invoices by invoice numbers.
Provide additional backup records with logs and calendars. Auditors will disallow deductions if documentation isn’t provided.
Treat the experience as an opportunity to improve your business.
After the Audit
- Keep track of correspondence with tax agencies.
- Send correspondence by certified mail.
- Stay compliant by filing on time.
Burdon of Proof
All expenses must be ordinary and necessary business expenses. More importantly, can you provide a business purpose for the expense? To audit-proof your business, each transaction must have a business reason.
- Ordinary expense – common and accepted for your industry
- Necessary expense – helpful and appropriate
Obtain, maintain, and retain records
- Records are now commonly available through online accounts
- POS terminals make it easy to retrieve lost and missing receipts from the vendor
Match documentation with every transaction on the bank and credit card statements
- An invoice for every income deposit
- A receipt for every expense
- Bank accounts
- Processor accounts
- Savings, brokerage, reserve, trust accounts
- Credit card accounts
- 1099’s with income
- Income records with bank statements
- Sales tax
- Payroll taxes
A few more tips to audit-proof your business:
- Never mix personal and business transactions
- Avoid cash transactions
- Use accounting software
- Use a mileage app
- File all required 1099’s and W-2s
- Know the rules for deductions
- Keep backup records
Audit-proofing your business requires paying attention to the financials and a partnership with an expert account and CPA. Using this approach to your accounting will provide assurance of accuracy.