Raising White Flags: Understanding the Dreaded Audit

May 9, 2019

What is an audit? It's a dreaded word that instills panic - especially for small business owners. Learn what an audit is and tips for surviving one.

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Toddler making a face and covering his ears

Some words are plain uncomfortable for us to hear.  Like colonoscopy, mammogram, and stress test.  While most people would probably prefer not to hear those words, much less discuss them – we know they’re a necessary evil if we want to be sure about the state of our health. 

Hearing the word “audit” is something that can cause a similar feeling of dread for small business owners.  The difference between a routine health check and an audit, is that in some situations, an audit is not elective—we have no choice but to comply.

To help you feel more comfortable with this stressful subject, you’re first going to learn the definition of an audit. You’ll also learn some of the best tips for getting through an audit.  A great way to go into this is with your guard down and mind open.  If you relax, this will be much less painful than you’re expecting!

What is an audit?

Put simply, an audit is a review of your business’s financial records and documents to ensure they’re correct.  Remember, the government and other institutions put specific rules and regulations in place to protect all interests involved.  While most businesses think of an IRS audit first, many different types of audits take place. 

First, there is the plain ol’ small business audit.  A small business owner would be smart to perform an annual audit of its own records, policies, and procedures. This assures books are accurate and in compliance with state and federal laws.

There is an insurance audit.  An insurance auditor’s concern is making sure your business is not unnecessarily liable. In short, they check for anything faulty that could lead to a false insurance claim. A claim, warranted or not, could cost the insurance company money. Obviously, they’d like to avoid forking out money, which is why they audit. 

The third and probably most recognizable is the IRS audit.  The IRS would perform an audit checking that the government is getting all the money due to them via taxes. 

According to research, approximately 2.5% of small businesses go through an audit each year in the United States.  That number might not seem too ominous unless you’ve experienced an audit, or know someone who has.  The IRS audit can be a very long, cumbersome, and costly experience for your business. 

what is an audit organize your paperwork

However, there are things you can do to minimize your chances of being targeted for an audit. There are also things you can do to get through an audit smoothly, should you be selected.

Who gets audited?

They can select any business or individual for an audit.  While we know very few small businesses are selected each year, individuals are even less likely of being audited, as only 1% of people are audited annually.

An important thing to note is that audit notices come in the mail—never via email or through a telephone call.  Beware of scams!  If anyone calls or emails you claiming to be the IRS and requesting sensitive information, don’t give them the information they’re seeking. Instead, notify the IRS immediately so they can warn others.  Do not return phone calls to a number the potential scammer supplies; look up the valid IRS phone number on the official IRS website.

Related:  IRS Adjusts 2018 HSA Contribution Limits for Family Coverage (Again)

What is a “red flag?”

A red flag is basically anything that triggers the IRS to look more closely at a business when reviewing tax returns.  The review process is a combination of both automated data reviews, as well as human review.  That means that it isn’t solely a computer or a human who will select your business for audit—it is both. 

The system and the IRS personnel are looking for anomalies—or data that breaks norms of what statistics show should be happening.  For example, if a business reports a loss multiple years in a row, that would be a red flag that something unusual is happening.  The IRS might be wondering how a company could continue to operate without making a profit so they would want to take a closer look.

How can I avoid raising red flags?

The best advice for avoiding raising any red flags is to do the right thing and do your research.

That sounds simple enough, but what exactly is the right thing to do during an audit?  For starters, be honest.  If you conduct business honestly, even if an audit comes along, you can feel confident you’ll come out on top.

Signs pointing different directions one says "right doing" and one says "wrong doing"

Next, a good thing to do to help create a degree of separation between you and your business is to outsource things like bookkeeping, payroll, and tax filing.  It’s understandable that some small businesses choose to keep all matters under their own roof to feel more in control or because of cash flow issues. 

However, finding a good bookkeeper, a reputable payroll company, and a certified accountant can give you peace of mind that your records are accurate and that certain liabilities are removed from you.  That’s right—many of these types of professionals will actually assume the responsibility, should something be calculated inaccurately.

If you choose to keep your bookkeeping, payroll, and tax filing in house, then it’s crucial you know the laws and information regarding all things business.  That means you’ll also need to be current in matters such as accounting and taxes, as well as employee rights and insurance matters.  When it comes to the audit, saying “I didn’t know” isn’t an acceptable excuse.

What do I need to do if I am audited by the IRS?

The first thing you will want to do if you are audited by the IRS (or any other agency) is to take a deep breath, and then slowly exhale.  You’ll make it through this process, but you might need to practice that deep breathing as you go.

After getting into the right frame of mind, here are some useful tips for helping you get through the audit:

  1. Respond to the notice immediately.  You only have approximately 30 days to respond to the notice, but don’t delay. You could forget and be penalized for non-response.  The non-response penalty is basically to expect a more invasive audit when the time finally comes.  And no one wants this process to be more stressful than it needs to be!
  2. Review the information and instructions on the notice.  Don’t just wait for the auditors to show up!  There will be things you will need to do to prepare for the IRS to inspect your records.
  3. Speaking of preparing, get your records organized with copies of all requested documents.  The process will only be prolonged if you must organize things as you go.  Your auditor will be a much happier person if he/she is not resentful that your records are in disarray.  Also, be sure that the documents are copies because you will not want to risk losing any original documentation during the audit.
  4. If you discover that something is missing from your records, it would be wise to replace the documents before the auditor arrives.  Discovering that anything is missing in the middle of an audit will only delay the process, and again make the auditor less patient.
  5. Comply with the auditor, and be cordial.  Are you starting to see a pattern here?  That’s right, your goal should be to avoid making your auditor have any reason to have animosity against you.  While you do want to stay on good terms, this does not mean you are not allowed to question or challenge your auditor—in a respectable way, of course.  It helps to know your taxpayer rights, of course, and to be well-versed in all matters of your business. Make sure you’re armed with information and not just a defensive opinion.
Related:  The IRS Will Never Call or Email You

Wave Your White Flag

In short, while an audit is not necessarily a comfortable experience to have, understand that it is necessary. It motivates business owners to stay in compliance with the laws of the land and holds them accountable for their taxes.  Knowing this, you might as well surrender, and wave your white flag. 

Think of it this way:  If there weren’t audits, then altering the books would be a regular part of the day-to-day business operations.  Audits are, and always will be, a way to keep businesses healthy and operating successfully for years to come.  So, help yourself and know what an audit is. Be sure to refer back to the helpful tips for getting through an audit, should your number be called. 

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