The first thing to do is stay calm. There’s no need to panic, since it’s likely either a random check or simply a request to confirm data. With receipt of a notice, fear of the unknown is a natural reaction; large penalties are typically incurred when the auditor can prove the mistake was a willful act and that the filer knew he or she was doing something illegal.
There are a variety of reasons why returns might be reviewed. In addition to the possibility of a random review, it could be something mistyped on a form or a piece of required documentation that is missing that has auditors interested in the return. For example, if a 1099 form is missing and the return was filed on time, the IRS might send a notice — just to acknowledge the form was missed and that the return needs to be changed to include it.
The auditor might seek backup information to support something that seems unusual, such as high charity-to-income ratio, or a sudden spike in deductions. Standard compliance checks are performed on payroll and 1099s, so if asked questions related to these topics, it may be a simple routine check based on a computer match.
From the taxpayer’s perspective, there is basically no difference between a state audit or an IRS review. There are, however, four different types or levels of reviews. The first two are pretty basic and can generally be handled by simply responding to the request. The last two audits are more complicated and most certainly would require skilled representation from an accountant or a lawyer specializing in tax issues and representation.
1. Notice. With notices, the auditor is usually looking for a response to some basic questions, such as missing information on the return. To meet these needs, simply respond to the questions as soon as possible and make corrections to the filing, if necessary.
2. Desk Audit. In this case, the auditor will ask for specific information or documentation. Once again, a quick response with the information being sought will usually satisfy the auditor’s needs.Depending on the outcome, changes may or may not be required on returns.
3. Issue Audit. This is where it becomes more complicated. The auditor will request a meeting or a visit to your office (in the case of a business) and will provide a list detailing the information being sought. Generally, these are either random checks or based on a specific item on the return. The review is usually focused on a certain area of the return. It’s best to seek professional advice if an Issue Audit notice is received.
4. Project Audit. This is a more complex audit, where the auditor will request a visit to your office to review all of the pertinent documents. This is a major endeavor and can last six to nine months. Typically, the largest costs end up being lost time and the expense of representation.
Expect the auditor to review everything in detail, especially anything out of the ordinary. It is typical for companies with more than $10 million in revenue to be audited every six to eight years. As annual revenues increase, audits can become more frequent. It is worth noting that S Corporations and partnerships are a current focus of the IRS.
Those are the types of reviews companies and executives can face. In order to best navigate the audit process, those targeted for an audit should heed the following six tips to in order to achieve the best outcome:
1. Respond Quickly. Gather all documents as quickly as possible to support the return. Expect the auditor to ask for basic information (for example, W-2s and 1099s for individuals and general ledger, balance sheets and income statements for businesses). They will provide a list of the expected items.
2. Seek Expert Advice. Do not try to go it alone. Always get expert advice from the filer’s accounting firm. The auditor and accountant speak the same language. For more complicated audits, advice from an expert whose focus is tax law may be required.
3. Be Patient. The IRS or a particular state taxing authority will not move quickly. It could be 60 days before they read a letter of response. They’ll keep sending collection notices, so stay on top of this. Don’t get frustrated.
4. Appeals Are an Option. If the result of the audit is unsatisfying, the option exists to file an appeal. The decision of the auditor is not binding. However, going to tax court can be a long and expensive process, which will probably involve hiring tax attorneys to handle the appeal. Decisions can be adjudicated on tax matters because it all comes down to the interpretation of the tax code.
5. Cooperation is Critical. Carefully review all of the information provided to see if there is something that’s been inadvertently missed. If something is found, let the auditor know immediately because self-disclosure always works to advantage. This sends a clear message of cooperation and of trying to do the right thing. It’s better to work with the auditors and not against them.
6. Change Behavior. If the auditor finds errors on the return, a behavior adjustment might be in order. If sales or meal taxes were a concern, be certain the state will be scrutinizing this information carefully in the future. So make sure it is all being done properly.
The importance of addressing every tax notice the subject of an audit receives cannot be emphasized enough. If all of the requested information is not immediately available, be upfront and let the tax review authority — whether state or federal — know that the information is being gathered and will be sent to them at a specific time.
Do not ignore the request, no matter how minor the material being sought may seem. They certainly won’t forget that information or a response is still owed.
Anthony Librot, CPA, MSF, is a shareholder of the accounting firm Waldron H. Rand & Co. PC. He provides accounting, audit, corporate tax and management advisory services to a diverse client base in varying industries, including real estate, hospitality, technology and manufacturing.
This article first appeared in Financial Executive magazine.