How to Prepare for a Business Audit

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. Instead, you should prepare.

What to Do Before Your IRS Tax 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

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 the auditor to go at it. Messy records mean more digging to the IRS, which 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 a Tax 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. The IRS accepts bank and credit card (Visa, MasterCard, American Express) statements 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, so 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's often used for both business and personal purposes. (IRC § 280F). Cell phones and vehicles used for both business and pleasure are designated as listed property.

Purely business equipment isn't 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. So, for example, if you use a car for business and personal use, keep track of the business portion. There are apps you can use or you can keep paper records.

If you haven't kept usage records of listed property, reconstruct them by memory or reference to projects 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 your car), 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.

Record of Travel and Business-Related Meals

By law, out-of-town business travel requires greater recordkeeping than most other expenses. You must have a written record of the specific business purpose of the travel and the costs incurred, such as meal expenses, as well as receipts. (IRC § 267).

A good way to document travel 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's okay to put together a log or diary after you have received an audit notice. But be upfront 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.

For business-related meals where you take a client or prospective client out to discuss business, you must have records showing the date of the meal, the cost (including tax and tip), the place of the meal, and the business relationship of the person you ate with. You don't need an actual receipt if the cost of the meal is less than $75.

Records of 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.

Read More Articles

Find out about IRS audit rates and the odds of being audited in What Are the Triggers of IRS Tax Audits?

Learn how much time most people spend doing business taxes.

Read about common tax deductions for individuals.

Getting Help

To learn more about small business tax audits and how to deal with the IRS, get Stand Up to the IRS by Frederick W. Daily and Stephen Fishman (Nolo) and Tax Savvy for Small Business, by Frederick W. Daily (Nolo).