What’s Worse: an IRS Audit or a Root Canal?

Going to the dentist and dealing with taxes are two things most people don’t really look forward to. And, like being informed that you need a root canal, the news of an audit is usually met with anxiety. However, audits are part of the reality of our system; they’re a prudent IRS process, meant to hold people accountable to the rules we have, regardless of our opinions on the fairness of those rules.

Technically, an audit, like a dentist appointment, can involve any number of things of varied complexity. It can be something as easy as the IRS requesting a simple proposed change notice because it received a W-2 or 1099 that was not reported on your return, to a request for additional information on your return, or even  a full on-site examination of your books and records.

The IRS now uses computers to match information across returns and, without any human involvement, issues notices related to missing or incorrectly reported 1099s. Without human oversight, these notices are becoming increasingly prevalent. Lately, the more intrusive full audits are also becoming  more frequent, especially for businesses and individuals with business activities or pass-through income. While the IRS won’t point to any specific reason for an audit, their system uses algorithms that highlight things considered to be deviations from the expected, and these anomalies may cause Uncle Sam to take a closer look.

Remember, the underlying intent of a business is to make a profit. If the IRS sees losses, especially repeatedly, they are going to start to notice. If the business is basically the sole source of income for someone, they will wonder how that taxpayer is supporting himself. If the taxpayer has lots of other income, they may assume the losses are fabricated to lower taxable income. I’ve seen audits in both of these situations. In both cases, the losses were legitimate and supportable, but the IRS required the taxpayer to “prove it.”

What can you do to avoid an audit or come through one unscathed?

  • Operate your business for profit. If that’s not your ultimate goal, this is where trouble can begin.
  • Maintain good records. Properly record your activity in an accounting system. Keep personal transactions separate from business dealings. Keep supporting documentation for sales and expenditures.
  • Document, document, document. Document loans, transfers between accounts, capital contributions and withdrawals, leases and other similar contracts; you’ll need these records if you get audited. If you can’t prove that a deposit was a loan or capital contribution, the IRS can assume it was revenue.
  • Take the deductions you deserve. Don’t be afraid of taking advantage of tax benefits just because it may cause a loss, or cause your return to “look unusual” in a given year. While an inquiry or audit may be a hassle, you should have nothing to fear if you’re following the other principles discussed here.
  • Consider the whole picture. Don’t always assume that deductions/losses are most desirable. Managing income and losses properly can save thousands in taxes and accomplish non-tax objectives. Seek advice and plan ahead.

This article was originally published in Illuminations: Facts & Figures from people with a brighter way, a Rea & Associates enewsletter, 8/15/2012.

Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.