Tax Audits – a Beginners Guide (Tips, Tricks, and Best Practices)

Tax audits can make or break your financial standing.

Having a governing body go through your records with a fine-toothed comb is never pleasant.

We are here to explain the process and help you prepare for it.

The Basics

A tax audit is a detailed investigation into a taxpayer’s finances, income, and taxation.

The practice’s goal is to ensure individuals and companies alike submit accurate reports on income and tax returns.

Who Can Conduct Tax Audits?

📋 The organizations that conduct tax audits include

• Internal revenue service (IRS) in the US
• Global accounting firms
• Internal auditors
• Supreme audit institutions
• Tax authorities

What Does the Process Entail?

The process typically focuses on the last three years, but in specific cases it can extend to six.

📋 During tax audits the governing body examines the taxpayer’s

• Income sources
• Deductions
• Credits
• Other financial documentation

Tax audits are extremely thorough and includes review all financial activity and reporting.

If the taxpayer’s papers don’t match, they can end up paying additional taxes or facing legal penalties.

Anyone can face tax audits.

However, the most common cases involve either the extremely wealthy or the extremely poor.

Types of Tax Audits

The process and goals of tax audits are the same in all cases.

There are three primary audit types, determined by the auditor:

• External audit: An independent CPA firm assesses financial statements, accounting policies, and internal controls
• Internal audit: Internal (organization’s or individual’s) auditors evaluate the financial reporting process and internal control to ensure accurate reporting
• Governing body audit: IRS or other body reviews accounts and financial information to ensure compliance with tax laws

Tax Audit Goals and Results

📋 There are four basic reasons to conduct an audit:

• Ensuring accuracy of books and statements
• Verifying regulatory compliance
• Improving internal control and accounting
• Showcasing financial accuracy

📋 There are three potential results:

• All papers are in order and no change is necessary
• The auditing body suggests changes and the taxpayer complies
• Changes are proposed but the taxpayer doesn’t agree, leading to further proceedings

Tax Audits – a Step by Step Analysis

The following are the key steps and aspects involved in a typical tax audit:

1. Selection Process

The governing body selects tax returns are selected for audit.

It uses various criteria, including

• Random selection,
• Red flags indicating inconsistencies or suspicious transactions,
• Industry-specific audits target specific professions or industries.

2. Notification

The taxpayer receives an official audit notice from the tax authority.

The notice specifies the scope, timeframe, and required documents for the audit.

3. Gathering Documents

The taxpayer collects relevant financial records, receipts, bank statements, and tax-related documents

📋 The documents most often include:

• Income statements,
• Expense records,
• Investment details,
• Supporting evidence for deductions.

4. Interview and Examination

The taxpayer meets with the auditor either in person or virtually.

The auditor carefully reviews the tax return line by line.

They taxpayer provides clarifications regarding income sources, deductions, credits, and other financial aspects.

5. Verification

The auditor cross-references the taxpayer’s records with third-party data to verify the accuracy of reported income and deductions.

📋 This data can include

• W-2 forms,
• 1099s,
• Bank statements

6. Adjustments and Discrepancies

If discrepancies are identified, the auditor proposes adjustments to the tax return.

It is up to the taxpayer to either agree with the results or ask for a formal appeal.

7. Penalties and Interest:

Underreporting income, negligence, or intentional fraud lead to penalties.

Interest accrues on any additional taxes the taxpayer owes.

8. Resolution

The audit concludes with one of the outcomes we’ve mentioned (agreement, disagreement, or no changes).

9. Appeals and Legal Action

The taxpayer can appeal within the tax authority or seek legal recourse if they don’t agree with the outcome.

10. Learning and Compliance

Regardless of the audit outcome, taxpayers gain insights into their financial practices and tax compliance.

The intention is to improve accuracy in future tax returns.

Taxpayers also gain insights into proper taxing methods and processes.

How to Prepare for Tax Audits?

Preparing for a tax audit can alleviate stress and ensure a smoother process.

Here are some best practices to consider:

1. Understand Audit Triggers

Tax audits are very rare. Only about 0.5% of taxpayers face them.

Yet, some actions can increase this likelihood.

📋 Here are the most common activities that trigger tax audits:

• Using round numbers in your tax return.
• Failure to report corporate employee salaries.
• High meal and entertainment deductions.
• Claiming your vehicle as 100% business use.
• Reporting higher income (this is not something to avoid; just be aware of the elevated audit risk).

2. Consult with a Tax Professional

Enlist the help of a licensed tax professional if you can’t keep up with your taxes.

In other words – consult with an enrolled agent, a certified public accountant (CPA), or an attorney.

They can guide you through the audit process, provide advice, and represent you if the need arises.

3. Keep Your Finances Organized

Maintain accurate records throughout the year. In other words – organize receipts, invoices, and financial documents.

Prepare income statements and forms, expense records and bank statements related to income and deductions.

Separate business and personal transactions clearly.

The best practice is to use separate bank accounts and credit cards for business expenses.

Keeping digital records can also help the entire process.

4. Keep Supporting Documents

Keeping detailed records for all claimed deductions is the best way to survive a tax audit.

This is especially important for business expenses.

📋 Make sure the supporting business expense documentation includes:

• Date
• Time
• Amount
• Participants
• Specific business purposes.

5. Understand Different Audit Processes

Even though the main principle of the audit doesn’t change, there are different ways to conduct the process.

Correspondence audits happen via mail.

The IRS can request you to send verification or additional documentation.

Office audits are less common. They happen at the IRS office.

In other words, you may have to show up personally to deliver the papers.

Field audits are the most comprehensive of the bunch.

The governing body will physically visit your residence or business and conduct the audit there.

📋 Prepare for these scenarios and make sure to familiarize yourself with your rights regarding

• Information you need to provide
• Legal representation
• Legislations applicable to your case.

Remember, preparation and accurate record-keeping can make the audit process less daunting.

Consult a professional, stay organized, and be transparent during the audit.

Additionally, you should know your rights and only answer the questions the law requires.

Conclusion

Tax audits are an important process that ensures legal compliance and correct tax records.

However, it is also extremely stressful for the person or organization being audited.

While there are no shortcuts, you can prepare for the audit and ensure smooth sailing.

We hope this concise guide has helped you relieve some stress.

Try Time Analytics!

Do you want to be as accurate as possible with your business expenses?

We have a solution.

Time Analytics is a time tracking software that eliminates confusion and errors when it comes to time and expense allocation.

The software connects time entries with their respective clients, projects, and tasks.

In other words, it provides accurate time logs that include fees and billing rates.

Creating the logs is unintrusive and intuitive, taking mere seconds to complete.

Allow your business to spread its wings and soar with effortless yet solid proof of work!

Jelena Lukic

Jelena has a Master’s Degree in teaching Serbian literature and language. Creative writing is her biggest passion.