If your business receives an audit notice, it doesn’t always mean you’ve done something wrong. Nevertheless, the time-consuming and potentially costly process of preparing for an audit can be daunting.
Here, we’ll outline essential information and strategies for managing corporate tax audits. This knowledge will help you understand the audit process, its key focus areas, and best practices.
Understanding Corporate Tax Audits
According to the IRS, an audit is a review of your organization’s accounts and financial information. The purpose is to ensure that information is reported correctly according to the tax laws.
Audits are usually based on returns filed within the last two years, but the selection criteria can vary. For example, your company may be chosen randomly based on the IRS’ statistical formulas. Alternatively, you could be selected due to issues or discrepancies in your tax filings.
That’s why it’s important to avoid what the IRS considers potential audit triggers.
Common triggers for corporate tax audits
Without a clear tax strategy and efficient financial management, your business could make an error that would warrant an IRS investigation.
- Misreporting income: Reporting a higher-than-average income, rounding your income up or down, averaging your income, or not reporting can all increase the chances of being audited.
- Disproportionate deduction reporting: The IRS pays attention to any business that claims a high number of deductions, or those which change your tax liability. This includes home office or travel deductions.
- Excessive expenses: Charging too many expenses or constantly changing your expense types could cause suspicion.
- Misclassification of employees: This is particularly relevant for businesses that employ independent contractors, as such individuals can lower insurance costs and reduce labor costs.
- Claiming business losses on a regular basis: If you file a loss for a number of years, the IRS may question your legitimacy.
- Having digital asset transactions: Trading with cryptocurrency or NFTs could warrant IRS interest, due to the increased levels of fraud for these assets.
- Running a cash-based business: This mainly affects smaller companies that receive cash tips, like hairdressers or restaurants. Many businesses fail to report cash income, so the IRS is strict about this.
- Having assets outside the country: If you are suspected of having over $10 000 in financial accounts without filing a Foreign Bank Account Report (FBAR), you may be subject to audit.
Regardless of why your business is selected, it’s worth noting that there are different kinds of audits.
The different types of corporate tax audits
The IRS can conduct one of four kinds of audits:
A correspondence audit
These are the most common and simplest audits, in which the IRS requests additional information about a specific part of your tax return.
An office audit
Here, the IRS may have more complex questions about your tax return. You’ll receive a letter asking you to come to an IRS office for the audit.
A field audit
This is the most comprehensive and serious audit and means a specialized field agent from the IRS will visit you at your office to examine your records. It might include a review of your financial records, interviews with employees, and a tour of the facility.
A taxpayer compliance measurement program (TCMP) audit
The IRS conducts a TCMP audit to update data for their Discriminant Function System (DIF) scores. These are conducted every few years, and participants are randomly selected.
Maintaining meticulous financial records is the best way to prepare for an audit. Not only do they make tax filings easier, but clear records help you provide evidence to any queries.
While the IRS generally only audits recent tax returns, they may ask for records dating back to a maximum of six years. As such, any documentation must be filed and preserved correctly for ease of access.
Typical requested documents include:
- Receipts, organized by date and purpose.
- Legal papers such as property acquisitions and loan agreements.
- Travel logs or tickets, including the business purpose and mileage.
- Insurance documents listing any thefts or loss documents.
- Employment documents, including shareholder income, losses, deductions, and credits.
To further prepare, ensure that you understand all audit requirements. A CPA or tax attorney can help you to review standards and regulations applicable to your business.
To eliminate any doubt about where you’re prepared for a potential audit, consider conducting a pre-audit risk assessment. With a governance, risk, and compliance (GRC) framework, you can identify potential areas of concern and rectify these before an audit.
How to organize and preserve the relevant documentation
The IRS recommends organizing your financial records by year and type of income or expense, including a summary of transactions.
You must have all the relevant documentation for income, losses, expenses, and deductions claimed on your return. To do this, efficient organization is key.
Start by ensuring that no personal records are included in your business documentation. Next, review the Audit Technique Guide (ATG) which the IRS uses for companies in your industry.
Ideally, keep digital copies of all relevant documentation. This allows for easy access and tracking, and can prevent anything being lost or damaged.
Establish an internal protocol for handling a potential audit
By setting up internal audit control procedures, your finance team can evaluate its financial reporting controls relevant to audit requirements.
Your protocol could include the following aspects:
- Planning and clarifying the scope: Have a clear audit plan and define a time frame for establishing processes. Using experience of previous audits, you can gather insights about best practices, and potential problem areas.
- Precise methodology: Clarify how to go about preparing for audits to ensure accuracy.
- Communication and reporting strategies: This will ensure everyone is clear on what must be done, and that reporting aligns with internal controls.
The Audit Notification
Essentially, an audit is the IRS’ way of informing you that they do not agree with your tax return, either entirely or in part.
For example, an automated adjustment notice informs you that the IRS changed something on your tax return it did not agree with, and does not usually require additional response from you.
However, if your company is subjected to a correspondence, office, field or TCMP audit, you need to respond appropriately, within 30 days of receipt. The notice letter will include the reason for the audit and advise you on how to handle the issue.
How legal and tax advisors can help
If you are unsure of any aspect of an audit notice or how to respond, it’s crucial to consult with a tax advisor or legal representation. Such professionals can advise you and guide you through audit preparation. After all, these experts understand the Internal Revenue Code. Moreover, they often have established relationships with the IRS to ensure that you can successfully navigate an audit.
Assessing the scope and potential impact of the audit
Depending on the type of corporate tax audits your company must undergo, the scope will vary. In addition, the scope is determined by the auditor, and therefore depends on your specific situation. Correspondence audits usually require you to submit additional information by return mail.
An office audit requires not only the relevant documentation, but your presence (or that of a representative like your tax attorney) at an IRS office.
A field audit, on the other hand, could significantly impact your business. In this case, an IRS representative will be interviewing employees, requesting additional information, or conducting a site tour.
Assembling An Audit Response Team
You can further streamline the audit process by establishing a dedicated team of internal and external advisors. Each person on the team must have clearly defined roles and responsibilities, along with relevant experience and expertise.
In addition to an external legal or tax advisor, internal staff are required. For instance, you could appoint representatives from HR, accounting and payroll, depending on which aspect of your tax return is in question. These individuals can then track any transactions which the auditor has questioned, while preparing the relevant documentation.
Your audit response team must have a coordinated and unified approach, to ensure that the audit process will run smoothly.
The Audit Process and What to Expect
The exact process of corporate tax audits depends on the type of audit your company must complete. Generally, the process is as follows:
- The audit notice. This will be sent by mail, and include details about what is required of you.
- A preliminary conference. Here, you can discuss the audit period, confirm dates and times or locations of office or field audits, and ask questions for clarification.
- Preparing documentation. You have 30 days to prepare the necessary audit documentation.
- Presenting documents. This can either be by return mail (for a correspondence audit), or in person at an IRS office or your business premises.
- Notification of audit findings. It can take anything between a few months and two years for the IRS to produce a Revenue Agent’s Report (RAR). This will include proposed adjustments to your tax return, amounts to be paid or refunded, or penalties.
- Acceptance or rejection of audit findings. If you accept the report findings, you’ll sign the report and arrange for payment of the outstanding amount, if necessary. If you do not accept, you can submit an appeal.
- A closing conference. At this stage, you can present additional information to adjust the audit findings, and establish any necessary corrective actions.
- Resolution. If you have agreed with the report and made the necessary changes or payments, the audit will be resolved. If you appeal or challenge the report findings, this may take time depending on the results.
During this process, a tax advisor or CPA can help you navigate any interactions with auditors and manage the flow of information.
Resolving Audit Findings
As mentioned above, it is possible to disagree with the findings of corporate tax audits. This can be done with an IRS manager, through a formal appeals process, or in the US Tax Court.
Strategies for negotiating settlements or adjustments
If you own a small business or self-employed individual, you can make use of Fast Track Settlement. In this process, you’ll work directly with an IRS representative to resolve your disputes, under a mediator assigned by the Office of Appeals.
This mediator will try to negotiate the settlement, which you can accept or reject. Typically, these cases can be settled in under 60 days.
However, if you do not have a specific IRS auditor assigned to your case, such as in a correspondence audit, you cannot participate in the program.
The appeals process and when to consider it
You have 30 days to file an appeal to the findings report for corporate tax audits. It is possible to request an extension, although if you’re granted an extension and lose the appeal, you may face penalties.
The basic procedure for appealing your audit findings is as follows:
- Do not sign or return your copy of the RAR. You’ll then receive a letter outlining the appeals process.
- File your official protest within 30 days of the date listed on the letter. Include your name and contact information, along with a statement that you want to appeal. Also, attach a copy of the proposed changes you are appealing and why you disagree. Include facts to support your appeal, and a signed penalty-of-perjury statement.
It can take up to a month (and sometimes longer) for a response. Use this time to prepare the necessary paperwork and other information you need to prove your appeal.
It’s worth noting that not all appeals are successful. IRS statistics indicate that the average appeal results in a 40% decrease in taxes, penalties, and interest imposed by the auditor.
After an audit, you may have to make changes or payments. In these situations, your company should adjust its audit policy in order to prevent the same issues in the future.
Depending on the outcome, your business may also need to review and update its tax strategies.
Proactive Tax Compliance and Planning
To ensure ongoing tax compliance and minimize the risk of future corporate tax audits, tax planning is essential.
This means keeping abreast of any changes to existing laws, and implementing effective record-keeping processes. By using software that ensures accurate reporting and conforms with tax regulations, you can ensure that your financial records are compliant.
Establishing internal controls and policies that align with regulations can further help your business remain compliant.
Finally, having a tax advisor is a great way to ensure that your business is compliant, and can take the necessary steps to avoid future audits.
It’s never fun to receive a notice for corporate tax audits. But by understanding the process, knowing what to expect, and enlisting the help of a professional, you can get through your audit with peace of mind.
For assistance with audit preparation, schedule a Discovery Call with one of our CPAs.
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.