RSM Resources

Over the past few years, midsized businesses and executives with incomes over $100,000 have been the focus of an aggressive Internal Revenue Service auditing effort to examine more tax returns. With that in mind, experts say good record-keeping and careful preparation of tax filings is more important than ever.

From 2003 to 2004, audits of companies with assets of more than $10 million rose 34 percent. During that same period, audits of high-income taxpayers rose 40 percent, with the IRS auditing 1.47 percent of taxpayers with incomes of $100,000 or more in 2004. IRS officials claim the numbers show the agency is making headway in its recent efforts to crack down on tax evaders.

"We’re ramping up enforcement, and there’s increased risk of detection," says IRS Commissioner Mark Everson."This is not a victimless crime. If a business cheats, it gets a competitive advantage that’s not good. If individuals cheat, persons who play by the rules pay more than a cheating neighbor."

While the overall odds of being audited remain small — less than two percent — the numbers show that high-income executives and midsized businesses are at greatest risk. Individual audits for taxpayers earning less than $100,000 a year have been flat or declining for the past several years, and audits of businesses with less than $10 million in assets fell from 0.58 percent in 2003 to 0.32 percent in 2004.

With audits of midsized businesses and high-income individuals on the rise, what can you do to reduce your chance of being chosen? In addition to staying abreast of changes in tax laws, experts say business leaders should be aware of triggers that can attract the attention of the IRS,including:

Incorrect basic information. Surprisingly, the IRS notes that most audits are triggered by incorrect reporting of Social Security numbers or reported income levels.

High-salary expenses in closely held corporations. The IRS looks for "unreasonable compensation" among officers in family-owned companies. To avoid unwanted scrutiny, make sure that salaries in these roles are in line with industry information. Ensure that your company keeps detailed records of hours worked, unique contributions that high-salaried employees provide to the business, and any other factors that influence spikes in pay for officers or executives.

Large itemized deductions. As an individual taxpayer, you may attract attention if your itemized deductions exceed a target range set by the IRS. The agency compares your deductions with others in your income bracket, and information generated by this comparison is used to select returns with the highest probability of producing additional tax revenue.

Auto, meal and entertainment expenses. IRS officials believe that many taxpayers claim business deductions for items and occasions that should actually be personal, nondeductible expenses. To deduct auto expenses, you must establish the percentage of business use as well as the actual expenses incurred. As an alternative, you can claim a deduction equal to the documented business miles multiplied by a published IRS rate (currently 44.5 cents per mile). You must have a receipt for all meal and entertainment expenditures of $75 or more, and the receipt must include the amount paid, the name and location of the restaurant or entertainment facility, the people you entertained, their business relationship with you, and the business discussion related to the occasion.

Cash-based business. If you own or work in a business with frequent cash transactions, such as food services or gaming, experts say you are much more likely to be audited. Make sure all cash received is properly reported on your tax return.

Deductions of a business loss. Taking a deduction for a sizable loss incurred while running a business may help shelter your income from taxes, but it may also attract some unwanted attention at the IRS. Make sure that you can document any business loss with receipts. Also, locate anything that can prove your intent to make a profit in your business, even if it is temporarily losing money.

If you think the IRS may question a large tax deduction or credit, attach an explanation along with documentation — such as copies of bills, checks or receipts — to your tax return when you file. While your return may still raise a red flag, the extra steps will demonstrate to an IRS reviewer that you know the rules, reducing the likelihood of a full audit.

Because the IRS has targeted several industries and occupations for special attention, the agency has created a series of Audit Technique Guides (ATGs) to help tax enforcers become familiar with these particular market segments. Many of these ATGs — which contain examination techniques, common and unique industry issues, business practices, and industry terminology — are published on the IRS Web site. These ATGs can be very useful reading for business owners who want to stay current with tax-related issues affecting their industry. The IRS site also publishes a series of coordinated issue papers on key business tax topics, which provide insight on current IRS thinking related to tax policy, trends and enforcement.

What to do if you’re selected for an audit

If you’re audited, experts say the first step is not to ignore the problem, since interest and penalties will most likely mount as time passes. The IRS will notify you by mail, and the letter will specify the type of audit they will conduct:

• Correspondence audit. In this type of review, the IRS sends a letter asking for more information about certain items on your return. You respond by sending in the appropriate documentation.
• Office audit. This procedure requires that you organize your tax paperwork and meet with an enforcement officer at your local IRS office. You have the option of going alone, going with a representative or sending someone in your place. "If you have perfect records and can back up everything, go ahead and take care of it yourself, but if you don’t, it may be in your best interest to hire a professional," says Fred Daily, tax attorney and author of Stand Up to the IRS.
• Field audit. This is the classic scenario where an IRS agent visits your home or business for a review.

The most important part of handling an IRS audit is preparation and documentation. You’ll save yourself time and aggravation in the long run if you are prepared for inquiries. For that reason, experts suggest that you thoroughly review your return, gather as much proof as possible to support any items in dispute and organize your paperwork before meeting with an IRS officer. Producing your documentation immediately when asked will speed the process and create a favorable impression.

On the other hand, don’t bring extra paperwork to justify deductions not in dispute, because placing those items under review may possibly open up issues better left alone. And, don’t volunteer information about items on your return that the IRS isn’t questioning.

By keeping complete and detailed records, you can substantially lessen your personal or business risks should the IRS decide it wants a closer look at your tax files.