How to Protect Yourself in an Audit
Jul 13, 2012
Audits are up--and will continue to increase--as the federal government implements its automated audit systems and increases its enforcement of tax collections. It is very important that you do your part in protecting yourself in the event of an audit by any agency. The way to do that is to document everything you receive and everything you spend for your business. Below are a few tips, per business type that we really want you to review (by no means are these the only tips, but at least they'll get you pointed in the right direction). Most of you are already doing your part, but just in case you need a reminder, here they are:
GROCERY/CONVENIENCE STORES/BARS/CONTRACTORS AND OTHER “CASH” BUSINESSES
This is a vulnerable type of business because of its cash component. Any time there are many cash transactions, auditors will want to check it out to make sure you’re reporting everything properly.
If your business falls in this category, you should definitely print ALL your register reports at the end of each shift. None of you should be operating your stores without a cash register, so this should not be a problem for you. There should be no unexplained gaps in register ticket numbers. Even if you have a rookie working the register with tons of input errors, you should still keep all “Z” tapes and give them to us so that we have the complete set of records, along with an explanation as to any errors. If your register system is computerized, please print a monthly summary report and include it with the work you give us. If you are a contractor, all your invoices should have preprinted, sequential, invoice numbers and there should be no breaks in the sequence. If an invoice gets voided, don’t just throw it away. Keep it and write “VOID” across it and write a sentence or two about why it was voided.
Try to avoid paying for things in cash; but if you must pay in cash, make sure you get a receipt that will serve as proof of payment. Saving a few hundred dollars on a “cash” job or purchase could end up costing you thousands if the auditor disallows the whole deduction because you can’t prove you paid for it. Always try to pay for all business expenses with either a check or business credit card (avoid writing checks to “cash”).
Audits of “cash” establishments tend to disallow some part of cost of goods sold when the owner takes products for personal use. It is not illegal for you to take food, supplies, etc for your home use (if you’re the owner, of course!), but it is not proper to include those amounts with your product costs. If you take supplies home, give us the dollar amount you take each month so we can back it out of the total cost deduction.
As for inventory, whether gasoline, or store products, you should try to run an inventory count at least twice a year, and definitely on the last day of the year. There are companies that provide this service for you, but if you’re doing it yourself, take the inventory and record it at your cost, not your sale price. This not only helps in audits, but in the event of an insurance claim (Katrina taught us a big lesson on that!).
Businesses that offer other services like ATM machines, Western Union, check cashing, bill payment agents, lottery, etc. Please keep track of those cash inflows because an auditor’s eyes will turn into dollar signs when they see that your sales only show $35K for the month but you deposited $85K into the checking account. They’ll say you didn’t report $50K in sales, when in reality, it’s all inflows from these convenience services you provide for your customers and you’re only seeing a few cents profit for these transactions! Most banks can set up separate “courtesy” checking accounts for these transactions to help keep cash inflows separate.
All records should be kept for a minimum of 3 years, but we recommend 5-7 years if you have space available, and try not to store them below sea level!
There are many businesses that don’t deal too much with cash. You may rely heavily on credit card and checks for payment. While you should definitely keep all sales printouts, you may not even have a register. Every business should keep some sort of log detailing the inflows of cash. Whether you choose to track it electronically with an invoice program, or by hand with carbonless receipt books, you must keep those records to show in the event of an audit.
The good thing about you not dealing with too much cash is that it is not too difficult to replace lost credit card company reports or bank statements that will help “reconstruct” your income. Even if you lose all your records, the audit process would be much easier since you can get most reports from “trusted sources” like banks and credit card companies to establish your cash inflow amounts.
If your business is service based, follow the invoice guidelines for contractors mentioned above. The weakness in these businesses is not so much on the income side, but the record keeping and substantiation of business expenses. For example, even though you may have had lunch with a client for business, if you can’t produce the meal receipt or log detailing the date, place, purpose of the meeting, and with whom the meeting was held, an auditor could disallow a deduction. If you have a business vehicle that you drove for 45K miles last year, you should have a mileage log or all vehicle expense receipts to support the deduction or it could get disallowed.
You also have the same issues as above regarding bringing stuff home for personal use (it shouldn’t get deducted), especially if you buy office supplies at retailers like Walmart, Target, Sam’s, Sears, etc, which sell all kinds of non-business products. This is where saving those receipts really pays off since all items will be listed on them and the auditor can see you bought a waste paper basket, paper towels, and batteries for the office clock instead of a case of diapers for your newborn!
The lesson for both types of businesses is to document everything. For expenses that could be viewed as personal (ex: liquor, skin creams, gift cards, floral arrangements, etc) that could all be client gifts or for office décor or use, write down more information on back of the receipt—otherwise you risk the auditor disallowing the deduction
We don’t want to scare you. We have spoken to other bookkeepers and tax preparers at national seminars and they all confirm that audits are in fact increasing. We want you to be prepared. You don’t have to be an organized person and have neat file folders for every single vendor or customer. You don’t have to be on that show, “Buried Alive” and keep 30 years’ worth of records. You don’t have to be all high-tech and scan every receipt and save it to a thumb drive.
All you have to do is keep all your business paperwork for 5-7 years. That's it. You can keep it all in plastic bins, folders, brown file envelopes, even plastic garbage bags—but just keep it. Believe me, having those records will make a BIG difference on the outcome of any tax audit.
If you ever receive any letter from any tax agency, please contact us before you call them so that we can discuss and recommend the best course of action to take. Sometimes, a simple letter or phone call is all that is needed. In complex cases, you may need to be represented by us.
We hope you never get letters concerning your taxes, but if you do, rest assured that, whether simple or complex, we’re here for you.