Preparing For An IRS Audit – sharing our experience so you know what to expect

As many of you know, our company was audited by the IRS this past year.  As a business owner, I have always had a slight fear of the Great Unknown Audit by the Big, Mean IRS.  But you know what, it really wasn’t so bad.  Seriously.  We keep solid books, and we’re honest about what we make and where the money goes, so the audit was a minor annoyance, nothing more.  The morning of the audit, one of my employees even said, “Oh, wow, I didn’t realize the audit was happening today. You seem so calm.”  And I was. Parts of the audit process were even downright amusing to me.  Either I have a twisted sense of humor, or I was just in one of those “well-I-have-to-laugh-because-what-else-can-I-do” situations. :-)

Obviously, though, I wouldn’t wish an audit on anyone.  I know many of our blog’s regular readers have their own artisan businesses.  Some of you may think you are “too small” to be in the IRS’ radar, but did you know that sole proprietors are 10 times more likely to be audited than other companies?¹  I’m writing this article so you have an idea of what might happen during an audit, and you can make sure you have all your ducks in a row in case you are ever audited.

The Notification Letter

In mid-May 2011, I received a letter from the IRS letting me know that my business’s federal tax return for 2009 had been “selected for examination.”  I was directed to call the IRS agent listed on the letter to schedule an initial conversation about the exam.  The letter indicated that someone could represent me during any part of the examination.

Did you notice anything weird about the above paragraph?  No mention of the word audit!  I was fairly certain that “examination” meant audit, but wasn’t 100% sure, so when I left a message with the agent, I said, “I am pretty sure I am being audited, but the word audit wasn’t mentioned in the letter, so I’m just checking…”  When the agent called back and left a message for me, she said, “I’m returning your call about the examination, um, I mean, audit. …” :-) OK, so I was being audited after all.

After a few days of phone tag, we spoke.  The agent said she would send a letter listing everything I’d need to have ready for the audit. She did mention a few items over the phone, and she also said that four line items on my tax return were “classified.”  This means they were going to take a closer look at those items for sure.  She said that they had been “classified” for  a specific reason, and when I asked her why, she replied that the computer wouldn’t letter her see that information because she didn’t have clearance to know.  Um…OK.

Our biggest show of the year was looming, and the agent was very understanding in setting the date for our audit.  We settled on July 6, which gave Blue Buddha about 6 weeks to prepare (really we had about 3 weeks to prepare, since we would be focusing on our big retail show for the first part of that timeframe).  This was fine by me. I wanted to get the darn thing over with sooner rather than later.

Items to be Examined by the IRS

A few days later, I received the massive list of everything I needed to prepare. Are you ready?  Here goes:

1 Copy of signed 2553 (S corporation Election)
2a Copy of 2008 Corporate Federal Tax Return
2b Copy of 2009 Corporate Federal Tax Return
2c Copy of 2010 Corporate Federal Tax Return
3a Copy of 2008 K-1 corporation
3b Copy of 2009 K-1 corporation
3c Copy of 2010 K-1 corporation
4 2009 personal 1040
5 Federal Income Tax Form 1056, 1120 or 1120
6a Forms 940 and 941 for 2009
6b W2s, W-3s, W-4s for 2009
6c 1099s filed for 2009
6d 1096s for 2009
7 Shareholder’s basis computations and At Risk computations for 2009
8 Schedule of distributions made to shareholders in 2009
9 Corporate Minute Book and stock certificate record
10 Original accounting records and books for 2009 as detailed below:
10a General Ledger/Subsidiary Ledger (ie Sales, Purchase, Account Receivables, Account Payables)
10b General Journal/Subsidiary Journey (ie Sales, Purchase, Account Receivables, Account Payables)
10c cash receipts journal (records of business income) ie Check Register
10d Cash disbursements journal (records of business expenses)
10e sales and purchases journals and ledgers
10f listings of the beginning and ending balances for accounts receivable and account payables
11 All invoices and/or financing statements for major business assets purchased and/or sold in 2009
12 Accountant workpapers regarding items below:
12a Year-end worksheet reconciling books to return
12b Year-end adjusting Journal Entries and Closing Entries
12c Year-end Bank Reconciliation
12d Cost of Goods Sold
12e Copies of financial statements
12f Beginning and Ending Inventory Valuations
12g Copies of financial statements prepared by 3rd parties
12h Trial Balance
12i Chart of Accounts
12j Depreciation Schedule
13 copies of correspondence with IRS for 2009
14 Records of all business loan activity proceeds and payments
14a Copies of all credit card statements, including Credit Card Advances from Dec 1 2008 – Jan 31 20019
15 Gross receipts
15a All books, journals ledges and work papers used in determining gross receipts
15b All bank statements and cancelled checks from Dec 1 2008 – Jan 31 20019
15c Copies of state sales tax returns for review during exam
Classified Issues:
Credit Card Fees
Legal and Professional Fees
Show Fees

OK. Deep breath. :-) As soon as I’d gotten over my initial shock, I entered everything into a spreadsheet. I created a column to indicate who I thought should be responsible for preparing the item (myself, my manager, the bookkeeper or the accountant).  Another column indicated progress, and a final column was left open for comments. I sent the spreadsheet to my CPA.

Then I called my bank to get the ball rolling on the “copies of all cancelled checks.”  We do our banking electronically, and it would be a pain to print up each check image one by one. I was certain they had a faster way to do it. I expected there would be a fee attached, but much to my delight, US Bank waived the fee. It was going to take a few weeks to send everything over, however they would do it for free.  Woo-hoo!  One item (almost) checked off the list!

My CPA called me that afternoon, completely astounded at the letter as well as the classified items.  “I’ve looked at all the entries in your Quickbooks file for each of those items, and absolutely nothing seems off,” she said.  “You didn’t even spend that much on travel; I have no idea why their red flag alarm was tripped.”

She went through the spreadsheet with me, marking off a few items that were not applicable to us (Woo-hoo! More items crossed off!) and making a few other notes. She also assured me that I could handle representing myself at the audit.

Over the next few weeks,  I worked with my manager, bookkeeper and CPA to gather everything needed.  It wasn’t difficult, just time-consuming. We had to dig through older folders to find specific receipts as well as make sure all the items that were saved as PDFs were well-organized. We went through every single entry in our Quickbooks  ledger to make sure it was accounted for correctly.  It was not the most thrilling thing I’ve ever done for my business, that’s for sure.

I’ve shared this list with you so that you can look through it and consider how quickly you could pull together everything on this list. If it would take you more than 20 hours (unless you are a multi-million dollar company), then your financial organization could probably use a little tweaking. Remember, too, that the IRS can audit any return for the previous three years (they can go back longer if there is a suspicion of tax fraud). It becomes significantly more difficult to remember the details of transactions for years you’ve already closed the books on.  You don’t want to have to spend hours trying to figure out what some payment was for, due to poor record keeping.

If you’ve read this list and are freaking out…take a breath. :-) First off, the odds of you being audited for a particular year are very small. Second of all, it’s not too late to get organized. You don’t have to go back and try to clean up your books from years past, but vow to keep great records in 2012 and beyond. Make sure to send your financials to your accountant not just at tax time, but at other points in the year to make sure you’re staying on track. And then, if you are ever audited, you can smile, knowing that you can handle it.

Stay tuned for tomorrow’s post, Surviving an IRS Audit, to learn what happened next in the process.

¹ 16 Tips to Avoid a Tax Audit of Your Small Business Return by Daniel Kehrer

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