Six Steps to Ease the Pain of an Audit

Experts suggest wise moves to make before and after the IRS comes calling.
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April 15 is long gone, but now is a good time to plan for next tax season. Avoiding an audit may be impossible, especially since the Internal Revenue Service has stepped up scrutiny of companies with assets of less than $250 million. But receiving an IRS letter should not spell the end of your business. Here are six steps experts say you should take to make the experience less painful.

Be a Bookie

Filing those receipts and keeping your records up to date will save you a major IRS-induced headache down the line. Programs like Intuit's QuickBooks and TurboTax can make the task easier and less time-consuming. Not only will they walk you through the process, they can cut checks and organize data for easy recall as well.

Ask for Help

Unless you majored in accounting in college, you should consult a tax expert. Your business model may be so simple that you don't need an accountant on staff, but it would be wise to occasionally talk to an expert to make sure you're up on the latest regulations. For example, to keep costs down, a client of Tom Ochsenschlager, CPA, hired freelance sales representatives to market their new sports clothing line. However, as the company grew, the sales reps had enough work representing only that brand that they stopped representing other clients.

As a result, Ochsenschlager, who is also vice president of taxation for The American Institute of Certified Public Accountants, advised his client to change the sales reps' status from independent contractors to employees. "If in your deal you tell them the hours they're working, provide them a location to work from, and they're working exclusively for you, they can probably be considered employees," he says.

So, befriend a tax preparer who works year-round. Frederick Daily -- author of several tax books, including

Stand Up to the IRS

(Nolo) -- recommends staying away from the chains since their tax preparers are seasonal. And for most small businesses, an enrolled agent should suffice. A certified public accountant should be used, says Daily, if the company grosses $1 million a year and has more than just you as an employee.

Hire the Right Tax Preparer

The IRS is less likely to audit you if your tax filer has a solid reputation with the government agency, says Jack Miller, author of

Simply Success: How to Start, Build, and Grow a Multimillion-Dollar Business the Old-Fashioned Way

(Wiley). "The IRS always looks at who signs the tax forms."

Honesty Is the Best Policy

Cash-based ventures face the most scrutiny. So report all income and deductions. But be careful about reporting a loss at the end of the year, says Daily. "The wife has a home business and the husband has a salary. Her business loses money. The effect is a lower tax liability. A small business loss will attract IRS attention. Perhaps forgo the loss rather than increase the audit risk."

Compensation is also another IRS attention grabber, says Ochsenschlager. "If you're paying yourself a small salary, you need documentation as to why you're retaining earnings in the corporation," he says. "You're going to pay taxes whether you distribute it as a salary or a dividend. You need a good rationale as to why you're keeping the money in the company."

Hit the Books

Outsourcing your bookkeeping won't keep the IRS at bay. You have to be able to defend your deductions and income. Miller recommends getting monthly financial statements and going over each line item with your expert. This can also help you plot strategy. "It's your GPS system," says Miller. "You can compare your projections to see where you are off and on. That way, you're prepared for the ups and downs way ahead of time."

If facing the IRS alone is too frightening, let your accountant handle it. Ochsenschlager recommends clients sign power of attorney over to him so he can handle the audits. Too often, he says, clients "have an attitude that an audit is adversarial in nature and get off on the wrong foot with the agent. They frequently don't understand the questions, and also often talk too much, which can raise issues in the agent's mind that don't exist."

Have Records on Hand

Should you get a letter from the IRS, don't panic. In most cases, they want to review information for that year. In some cases, they'll go back further. Ochsenschlager recommends holding onto three years' worth of records, six years if you're a cash-based enterprise.

And don't be afraid to stand up to the IRS, says Miller. When he ran the office supply company Quill Corporation, they were sued by North Dakota for sales tax collection. "But the only thing we had was we were distributing free discs to customers so they could keep track of their purchases," recalls Miller, then founder, president and CEO of Quill. "We won in the lower courts. North Dakota won in their supreme court. We appealed to the U.S. Supreme Court. After $1 million in legal fees, we won the case."

Continues Miller, "If North Dakota had won, we would have had to start collecting taxes in every state we had business, which would have meant having a state auditor in our business every year. We would have 50 audits every year. If you feel you're right and you're willing to fight, then you can prevail. Make sure you have good expert advice, top flight accounting and legal firms."

Lan Nguyen is a freelance writer based in New York City. She has written for the New York Daily News, The Wall Street Journal, Worth magazine and Star magazine.