How to protect your Texas business when you receive an IRS audit letter.

Take these steps:

1. Review Your IRS Audit Letter and Identify What Items On Your Tax Return Are Being Audited.
IRS’ audit letter will list the items IRS initially intends to examine.  For instance, IRS will always identify income as one of several items it will review.  During the audit, IRS will request your bank statements (and review your deposits) to calculate your income and confirm the income you reported matches IRS’ bank deposit analysis (BDA).  If you refuse to provide your bank statements, IRS will send a Summons directly to your bank and get your statements, cancelled checks, and deposit images.  A BDA is performed for individuals and business owners, even if you own less than 50% in the company.  Other items IRS typically examines on a return include:

  • Schedule A expenses: medical expense deductions, state income tax payments, mortgage interest deductions, donations, casualty losses, ad other expenses not reimbursed by your employer;
  • Net Operating Losses (NOLs): if you are carrying-forward losses from a prior year, you will need to establish the loss occurred and actual amount of the loss (starting with the year the loss arose until the present year).  The proof you will need includes transactional documents (source documents) for the transaction(s) that created the loss as well as how the loss was consumed (or increased with additional losses) for each year;
  • Schedule C: this schedule is used by sole-proprietors (or single member LLC owners) and reports both income and expenses associated with the business.  Pay particular attention to the amount of expenses in relation to the amount of income reported. For instance, if you reported $100k of income and $80k of expenses, is the $20k net income typical for your business and for your industry?  If you report a loss (your expenses exceed your reported income), your business may be labeled as a hobby unless you can establish you had a “profit motive” and a loss was incurred despite your attempt to make a profit (i.e. you can show you have advertising and made other investments that are necessary and ordinary to attempt to make a profit).  Pay particular attention to expenses reported under “other expenses” (line 27a).  This amount is broken out on page 2 of your Schedule C and may also be further detailed on a separate schedule (called a “Statement”) towards the end of your tax return.
  • Payments to independent contractors: payments to individuals or other businesses for services in connection with your business activities should have a 1099-NEC or 1099-MISC for payments $600 and greater (i.e. marketing services, repairs & maintenance, etc.).  If you paid your contractor with a credit card, then a 1099-NEC or 1099-MISC may not be required as your payment would already be reported by the recipient’s merchant provider on a 1099-K.

2. Gather Your Documents & Confirm Your Financial Records Match the Income and Expense Amounts Reported on Your Tax Return. After you identify what items IRS is interested in, you must provide documents to support the amount you reported for gross revenue and expenses. You will want to gather your General Ledger (a report that lists all your business transactions for each year); bank statements, copy of your tax return (yes, IRS will request you to provide a copy even though they already have a digital copy), and copies of invoices you paid during each year under audit.  Also focus on large expenses that are reported under “Other Expenses”, which may catch the auditor’s attention.  There are alternative methods to establish various expenses where you are unable to find source documents.  Start by contacting your vendors and service providers for a statement of invoices and payments you made for each year under audit.  For payments to small companies (who may not keep detailed records), try to find email correspondence that supports the payment and what was provided (i.e. description of services or product purchased).  Note that banks will only retain your records (bank statements, checks, and deposits) for 7 years.  You will need to explain any discrepancies between your records and the amount reported on your tax return.  Also, if you give documents to IRS that are incomplete or go beyond the issues IRS initially identified in the audit letter, you may increase the scope of your audit to include new issues, additional business transactions, and additional tax years that were not originally requested.

3. Credibility is everything.  Yes, first impressions with IRS do actually count.  If your records are inaccurate and your explanations are not accurate, the IRS Revenue Agent will doubt that you are providing truthful and complete information.  The IRS Revenue Agent may then decide to send a legal Summons to your bank and third-parties (which can include people you have done business with). Keeping your financial status confidential is important to business owners.  No one wants to have IRS contact their clients or vendors.   

4. Don’t Ignore the IRS
While you may be tempted to ignore the IRS when they reach out to you, failing to respond by the deadline will make matters worse. If you do not respond to an audit notice, IRS will contact third-parties and eventually close the audit by disallowing all of your expenses. Essentially, you will taxed on 100% of your business income (with no deductions) and also assessed penalties, and interest.

5. Call an Experienced IRS Lawyer
Retain an experienced tax attorney from the start of the audit.  Ensure your documents are consistent (or possibly provide a reasonable and truthful explanation for the discrepancy) and ensure a strategy is in place to handle issues identified in the beginning of the audit.  For instance, if you discover you inadvertently did not report a large amount of income, your tax attorney will have the opportunity to develop a defense before documents are provided to IRS.  It is critical to develop a narrative to explain an issue to IRS that provides a plausible defense rather than having IRS identify the problem on their own, which will then create further distrust and possibly encourage IRS to dig further into more transactions and additional tax years.  Furthermore, your communication with your tax attorney is protected by the attorney-client privilege.  Discussions you have with your CPA, however, is not protected.  One caveat to keep in mind – your communication with an attorney may not be protected if your tax attorney prepares your tax return but would be protected for discussions relating to legal advice. Qualified tax attorneys do typically work with a company’s CPA (who is familiar with the company’s business transactions) to obtain the correct documents and information to support a defense.  Remember, anything you say or communicate directly to IRS (without an attorney) can and will be used against you.  Having an experienced tax attorney can help you navigate the complex audit process and make better strategic decisions, even after the audit concludes and a decision may need to be made to file an Appeal or filing a Petition with the United States Tax Court.

We recommend businesses hire an experienced tax attorney and not represent themselves. Otherwise, you are placing your business and assets at risk. With the right financial and legal experts at your side, you can successfully navigate this complex process. Once you have received notice of an audit, contact an IRS attorney who can analyze legal rights and defenses.

If you have any questions about the information above, please contact Milikowsky Tax Law.

CALL: (858) 450-1040

At Milikowsky Tax Law, we keep businesses in business.