Few things strike terror into the heart of the average business owner like a tax audit notice from the IRS. Visions of hours spent collecting thousands of pages of documentation culminate in fears of monetary penalties or, worse, criminal sanctions.
In an effort to escape the IRS bogeyman, many clients run directly to their attorney’s office. Since most business lawyers are not tax practitioners, however, and have limited experience with either the IRS or reading financial statements, you may want to enlist the assistance of a CPA. The more complicated the situation, the more advisable this team approach becomes.
Here are the basic steps to take when preparing a client for an audit:
Have the client file a power of attorney with the IRS. The IRS takes its duty to protect taxpayer privacy seriously, so before divulging any information to a third party (including attorneys and CPAs), there must be a power of attorney on file. And not just any power of attorney — like everything else, the IRS has forms specifically for the purpose (2848 and 8821). Make sure you include years previous and subsequent to the audit year.
Review the return for possible red flags. The audit notice will specify what year(s) the audit covers. Review the specified returns looking for anything an auditor might be interested in. Think a couple moves ahead; it’s okay if you spot some issues the auditor might have missed. Have a frank meeting with the client to discuss any questions or irregularities you discover, so you know ahead of time where the potential landmines are.
Clarify what issues the auditor wants to review and what documentation will be required. Contact the auditor to clarify (and demarcate) these issues. If the auditor wants to review charitable contributions, your job is to limit the discussion to that topic — and don’t, for example, volunteer an offsetting error in another part of the return.
Of course, the auditor is free to expand the scope of the audit at any time. The goal throughout is to be sufficiently prepared and organized so the auditor doesn’t have the opportunity or inclination to go on a fishing expedition into other parts of the return.
Arrange audit meetings away from either the client’s site or the auditor’s office. Meeting at a location away from the client’s business is another way to limit the auditor’s scope of inquiry to issues identified on the return. Anything the auditor sees or hears at the client’s site could potentially give rise to further questions.
At the same time, though, it’s better not to meet on the auditor’s home turf where he or she will have no reason to wrap up the meeting expeditiously in order to get back to the office. Instead, offer a neutral space; the attorney’s or CPA’s office is perfect for this purpose.
Decide if and when the client should be present at the audit. Unlike a jury disappointed because a criminal defendant didn’t take the witness stand, an IRS auditor will not suspect the worst if the client is not present at the audit. Many clients feel intimidated or even guilt-ridden by an audit because they are so personally involved in the outcome, and will welcome the opportunity to skip as much of the proceedings as possible.
If there are highly technical questions (such as characterizing passive versus active income), the client most likely will not have anything to add to the discussion. Or, if the client does participate, it may be to volunteer information that is tangential and will lead the auditor in a direction you’d rather not go.
Create detailed schedules summarizing all documentation. In addition to presenting the raw documentation, you want to be able to show that information in the light most favorable to your client. And, to the extent possible, you want to minimize the number of follow-up questions.
A well-structured summary can do just that, leading the auditor to see things in a way most favorable to your client and making detailed investigation of the supporting data seem superfluous. Having a CPA create these summary schedules in formats that will be familiar to the auditor (e.g., tax or financial statements) also will increase the auditor’s comfort level with the data and reduce the likelihood of further scrutiny.
Be prepared to explain any discrepancies that exist in the documentation. If you’ve thoroughly reviewed the financial information, you may find instances where different documents appear to paint different pictures of the business. Suppose, for example, that bank deposits exceed business income declared on the return. There could be a simple explanation for this, such as owner contributions to the business. If you have this explanation at hand, that will be one less reason for the auditor to delve more deeply and possibly turn up other, more serious, problems.
Have previous and subsequent years’ documentation and summaries at hand. If the return in question includes a carry-back or carry-forward to or from another year, have documentation from those years ready to present. Otherwise, while you’re taking the time to prepare the information, the auditor has time to think about the return and perhaps find additional questions.
In most cases, the attorney’s role should be to lead behind the scenes. While it is advisable to have someone accompany the client to the audit, the presence of an attorney (rather than a CPA) could signal to the IRS that there are some serious problems with the return. On the other hand, the auditor is more likely to see a CPA as a peer, which can help the process run more smoothly. And a CPA can be invaluable in organizing information into a form that the auditor will recognize without laboring over.
With some careful preparation, you and your client will be able to survive an IRS audit. Whether you bring along fresh garlic is up to you.
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Brett Rice, CPA, is a senior account manager with Anderson ZurMuehlen & Co. in Seattle. His practice includes addressing the financial and reporting requirements of small businesses and developing structured solutions that meet their needs. Rice can be reached at brice@azworld.com.
