Preparing For A Tax Audit

Low thunder in the distance. A little pang in your tooth. An unusual grinding sound when you start the car. Trouble brewing.

And then there’s the unexpected letter in the mailbox with the IRS’s return address.

Of course, sometimes such a letter can contain neutral or even good news. I recently received a letter from the IRS telling me that my return had understated the amount of estimated taxes I had sent in over the year, so my refund was going to be larger than I thought. (Thanks for catching that, IRS!)

Another year they pointed out a simple subtraction error that increased the amount of taxes I owed by

 a couple of hundred dollars. (As an accomplished financial professional, I have now mastered the fact that 6-2 = 4, not 2.)

Still, sometimes that letter is notification of an audit, but even that may not be bad news because not all audits are created equal. There are audits, and then there are AUDITS.

• A Correspondence Audit is the most frequent type of audit and is simply a request from the IRS for documentation, usually of one or more deductions you took on a tax return. You receive the request by mail and can reply by mail, and that may be all there is to it.

• A Field Audit occurs when the IRS wants to verify information by looking at something physically. This type of audit may occur if, for example, you’ve taken a deduction for building a home office or made improvements to a business site.

• An Office Audit is the type that most people visualize when they think of audits: the dreaded summons to an IRS office to provide requested information and documentation. However, no audit needs to be really bad news if you’ve done the three things you most need to do to prepare: Keep good records during the tax year, be honest when preparing your taxes, and keep thorough notes on how you arrived at each line on your tax form.

Keep Good Records During The Tax Year

The time to begin preparing for an audit is a year and a quarter before you file your taxes for that year — on Jan. 1 of the tax year. The hidden benefit of doing this is that it will make the chore of preparing your taxes easier.

If you deduct business mileage, start keeping a mileage log in your car on Jan. 1. If you deduct sales taxes (which we can do in Texas because we don’t have a state income tax), start keeping receipts on Jan. 1. If you use a computer or other equipment for both business and personal use (called “listed property”), start keeping a log of when and for how long you use that equipment for each one.

If you have a business expense, keep all the documentation you might need down the road to prove it was a legitimate expense — not just receipts, but trip reports, conference descriptions and programs, photographs, bank statements, invoices, credit card statements, appointment books and logs, business related leases, and everything else you can think of. A friend of mine did a major renovation of his business site and photographed every aspect of the project, from start to finish.

Stuff everything in a folder if you want to, but set aside time on the first of each month to go through that month’s paperwork and organize it. If you keep records on a computer, back up your files no less often than on the first of each month.

If you aren’t able to produce adequate records, the IRS can make its own estimate of your income and expenses AND impose a penalty for your failure to keep records. Even if you were as honest as you could be, the IRS needs to know that honesty was based on facts, not magical numbers swirling in the air above your head.

On Jan. 1 after the tax year is over, start watching your mail for W2s, 1099s and other records from employers, banks, investments and so on. Having these on hand will make filling out your tax forms infinitely easier.