Preventing Tax Audits
The best tax audit is the audit that never happens, obviously. There are two major elements in avoiding an audit --
- By never doing anything that the IRS could possibly be interested in (very difficult), and
- By being careful how tax affairs are reported to the IRS (an art form)
Some taxpayers may choose to take the path of never doing anything that the IRS could be interested in, but in order to do that, they would have to know all of the tax laws, rules and interpretations better than any CPA. This just isn't practical. For clients who want to minimize their audit risk in this manner, I try to stay aware of their financial and tax activity and alert them to the issues involved. Actually, I do that with all of my clients.
Early in my practice, I had an experience that taught me much about the "art form" of tax return preparation:
My client had a sole proprietorship that created local area directories to put in hotel rooms. When he brought me his records, one of the expenses was "artwork" which is what he paid to have the material produced for the directories. I routinely listed the expense on the tax return just that way -- "artwork."
One year, he sold the business, but still had some expenses that he had to pay off in the following year. So in that following year, he had a business return with expenses and no income. The IRS is generally suspicious of this because they suspect that without revenues, it may not be a valid business. Naturally, my client was audited. It was not very difficult to explain why there were expenses without revenues, and the documents from the sale of the business demonstrated that.
The agent disallowed the deduction for "artwork" because he was thinking of "artwork" as a painting or sculpture. Once again, we were able to prove our case and have the deduction allowed on the basis of the facts, not the agent's miss-impression.
Now, when I have a terminated business, I make sure that I state so clearly. For example, I might use the second line of the company name to say "Sold June 30, 2003" so that when a reviewer in the IRS looks at the return to decide whether it needs an audit or not, they will conclude that there is a good reason for it to be filed this way. Also, I would now describe the "artwork" expense as "graphic artist services" or the like.
In the end, we prevailed on all issues, but we could have saved a lot of headaches by presenting the information differently. Now, I carefully practice the art form of tax return preparation in addition to the technical preparation. This has saved my clients and me from any number of "dead end" audits over the years.
Management of Your Audit Risk
In addition to being conservative in your affairs and having your tax returns "artfully" prepared, there is one very important technique for winning in an audit -- keep good records!
If you do not have records to support the positions taken, the IRS can interpret the facts to their benefit and you have little left with which to defend your position.
