How to Survive a Tax Audit

Tax audits can be stressful, time consuming and potentially expensive. Small-business owners, who might be navigating complex business tax rules for the first time or who work in cash businesses like restaurants where mistakes are easy to make, are especially likely to attract unwanted attention from the Internal Revenue Service.

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The good news is that an audit doesn't have to be an endless, painful, invasive process, says James Guarino, a certified public accountant and a partner at Moody Famiglietti & Andronico in Tewksbury, Mass. You can even emerge without owing more money. Here are some tips for minimizing the pain of an audit.

1. Keep things in perspective. Few audits are the "full body scan" or line-by-line examination of a return that people imagine when they envision an IRS probe, Guarino says.

Often there is a math error, and the supporting documents such as 1099s don't match the figures on a company's return. Addressing the IRS's concern could be as simple as supplying a missing document or fixing an incorrect 1099 and redoing the math on the tax form.

Beyond that, sometimes a single aspect of a return will raise a red flag and the IRS will ask for additional supporting material. For example, professional real-estate investors can claim losses and write-offs that casual investors might not be able to, Guarino explains. "But you have to meet certain criteria to be a professional rather than run-of-the-mill investor." So if an entrepreneur makes this claim but the investment activity doesn't fall into the range that's typical for professionals, the IRS might ask for further substantiation of that status.

2. Get help. Larry Elkin, a certified public accountant in Scarsdale, N.Y., says that when he was audited, he never dealt with the IRS directly. "Hiring an attorney or CPA takes the emotion out of it," says Elkin, who is president of Palisades Hudson Financial Group, a financial planning firm.And experienced tax lawyers and accountants can recognize when an issue isn't as black-and-white as an agent might assert.

"There can be a lot of shades of gray," Guarino says. "Your audit could relate to a deduction that's controversial, where the IRS always tries to take an aggressive stance but where every time it's gone to court, it's lost."

Elkin concurs. "The audit agent will write up points" that allege a client owes money, he says. "We often argue and win because they don't want taxpayers to appeal the levy in court and win."

3. Provide exactly what the agent asks for. Resist the urge to volunteer information. It's ideal to provide no less, but no more than the IRS requests. The best way to get an IRS audit over with quickly is to keep it confined to the single issue initially raised.

If you talk directly to the audit agents, Guarino says, answer with direct speech: "Yes; no; I'll look into it," he says. "Any tidbit of information that you offer could bring things to the auditor's attention that he might not have thought of otherwise. That could open a new can of worms."

This is another reason in favor of having someone else represent you in an audit, Elkin says. "If I had dealt directly with the agent, I might have invited an open-ended fishing expedition. The other way the agent had to decide what he wanted to know. He asked and we answered."

4. Don't assume the IRS is right. Agents can make mathematical errors or overlook important documents as easily as a taxpayer can. And when laws or financial values are open to interpretation, the auditor will take the stance that benefits the IRS, the experts say. That doesn't mean you can't successfully argue the opposite point of view.

For example, if you donate a piece of art to a nonprofit, "no one is going to dispute that it's deductible, but you can disagree over the size of the deduction," Elkin says.

In that case, it's up to you as a business owner to provide documents, such as appraisals or auction prices for similar items, to substantiate your claimed deduction. If you can do so, the agent might have to accept it or agree to a compromise number.

5. Decline requests to extend the IRS's deadline. Because of a backlog of cases, the IRS routinely asks owners of companies that are audit targets to waive the statute of limitations usually restricting probes to the three years previous. "You should say no," Elkin says.

"Taxpayers have a few months to get their taxes together and the government has three years to audit them," he says. "That's enough. You don't have to endlessly accommodate them."

Elkin cautions that the written request for a waiver might not read like a request and it might seem as if you have no choice but to agree. Rather than be intimidated by the legalese, check with a tax adviser before responding.

Sticking to a firm deadline with the IRS probably won't release you from an audit. "The agent will finish as much as possible in the time allowed," Elkin says. "If he's right, you should pay the claim; if he's not, you should dispute it."

Either way, a proper response should bring the audit to a prompt close so that you can move on—and start getting ready for the next tax season.