If your business is ever subject to an audit, it is important that you know the general procedure that the IRS agent will conduct in their examination. Some of the things that an IRS agent will conduct are interviews, touring the business facilities, inspecting the businesses internal controls and many more. It is important that you understand that these procedures need to be carried out correctly by the IRS agent or the audit could be subject to objections in court. All IRS agents are given audit manuals that show them exactly how to carry out an audit. This manual can be found online by going to the IRS website.
Inspecting Your Business Internal Controls
The first order of business for the IRS agent will be to conduct a thorough investigation of your businesses internal controls. Your internal controls are how your business keeps its financial statements clean and free of material mistakes. Things like how you segregate duties and keep your checks from being used incorrectly will be very important to the IRS agent. This procedure happens first because it gives the agent the ability to sort through high risk and low risk accounts and which of those have any tax consequences.
The way the IRS is going to test your internal controls can be crucial to how your audit will go. It is important that your internal controls match the tax return and transactions that are being reported to the IRS. The agent will go through all the steps in your operation cycle from start to finish determining if the accounting information he is receiving matches what is on your books.
Your Books & Records
Once the IRS agent has finished going through your internal controls he will begin going over your past books and records. There are many steps in this process, these steps include:
1. First the agent is going to determine what books and records there are for him to examine. Depending on how your business is setup, you could have unlimited combinations and variations of how you conduct and account for your business.
2. The IRS wants to understand from your point of view how a transaction in your business occurs from start to finish. Therefore, the agent is going to request that you explain to him the way a transaction is created, how and where it flows and where it ultimately ends up. This can entail going through a whole cycle involving your statement of cash flows, balance sheet and income statement. The IRS also wants to make sure that you have complied with the rules that accompany your annual accounting period. Depending on whether you use a fiscal or calendar year will ultimately change this outcome.
3. Next they will move on to finding out if you are in compliance with one of the various methods of accounting. Depending on your business model and the income it produces it could be cash method, accrual method or other combinations. It’s important that your accounting method is in compliance with the IRS and how they recommend you should account for your business.
4. The last step the IRS agent will take with your books and records is actually tracing transactions from your books to your tax return. These things include going through your trial balance, your individual transactions, reviewing your adjusting entries and various other methods for comparing your tax return to your books.
Your Balance Sheet
It is very important that your balance sheet has been accounted for correctly. If you are a partnership or corporation the IRS wants to view your balance sheet and see if there are any usual accounts present. Examples of unusual accounts that could be a problem would include large accounts that pop up seemingly overnight, accounts containing no name, accounts with a high volume of transactions and things of this nature.
Cash Intensive Businesses Beware
If you run a business that is very cash intensive, the IRS is going to be very interested in how you have recorded your cash receipts and whether you have recorded all transactions. The manual that is used by the IRS agent is going to have them look for transactions that have been skimmed, stolen after it was recorded and any other fraudulent activity designed to evade taxes.
A big tip off for the IRS when it comes to catching someone that is not reporting all their cash receipts is an unusually low profit margin that would make it hard for the owner to live and continue the business. This margin has to be something that is continuous over a long period of time. The IRS will also verify your life style and compare it to the income you are reporting. If your lifestyle far exceeds what you are reporting you may have a problem with the IRS. Another way the IRS can catch you is if you continually report a loss year after year and show no signs of trying to fix it.
In situations where significant cash has been skimmed off the top, the books and records will not be of any use because they will ultimately match up. This is when the IRS will take an indirect approach and begin trying to estimate your income and expenditures to see if they are matching what you have reported on your tax return.
Do you have an online presence?
The IRS will actually use techniques to go back and view your online activity in the years that they are investigating. This can give them an idea about your income level, if you have taken proper deductions and various other things that should line up with your tax return. One way the IRS can view your website from past years is to use a website called archive.org. This website will give them everything they need to see how your website looked and the ability to estimate your websites income level.