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Getting a notice that your small business is being audited by the Internal Revenue Service (IRS) can be a stressful experience. If you know what to expect and prepare ahead of time then the whole procedure will be a lot less painful.

How the IRS Selects Returns for Examination

The process that the IRS uses to select a return for examination usually begins in one of two ways.

• First, the IRS uses computer programs to identify returns that may have incorrect amounts.
• Second, the IRS uses information from outside sources that indicates that a return may have incorrect amounts. These sources may include newspapers, public records and individuals.

Publication 556 - Examination of Returns, Appeal Rights, and Claims for Refund, explains the rules and procedures that the IRS follows in examinations.

Kinds of Audits

Tax returns that have been selected for examination, whether automatically by computer or manual identification, are scanned by screeners in order to determine the scope and type of examination warranted. There are two types of audits: Campus Examinations and Area Office Examinations.

Campus Examinations are limited examinations involving relatively simple issues that can be resolved by verification submitted through the mail. The Campus, which will be one of the ten service centers that are located throughout the country where tax returns are filed, conducts all aspects of the examination, including the initial contact letter requesting information or a response from the taxpayer, the 30-day letter and the notice of deficiency.

The Campus Examination begins with the initial contact letter or telephone contact that requests information or proposes changes to the return. The taxpayer may respond to the initial contact by:

• Agreeing to the correction
• Requesting additional explanation for the correction
• Providing the information requested
• Requesting a personal interview
• Not responding or not agreeing to the correction.

If the taxpayer requests an additional explanation of the correction, that request is forwarded to a tax examiner to contact the taxpayer with a letter or by telephone within 30 days. If the taxpayer provides the information requested and it is satisfactory, the return is accepted without change and the IRS sends the taxpayer a no-change letter.

If the taxpayer's explanation is not satisfactory, the Campus sends a 30-day letter to the taxpayer, advising the taxpayer of the proposed tax change and of the taxpayer's appeal rights. If the taxpayer requests an interview, the Campus makes telephone contact to try and resolve the case. If unsuccessful, the Campus transfers the case to the area office and the taxpayer is notified of the transfer.

There are two main types of Area Office Examinations:

• Office Examinations in which the taxpayer is invited to bring his or her books and records to a local IRS office to resolve any issues
• Field Examinations in which the revenue agent visits the taxpayer's home or place of business to conduct the examination

In certain instances, a return will be selected for correspondence examination if all the questioned items are susceptible to direct verification from records that could be easily submitted by mail and there are clear indications from review of the tax return that the taxpayer can effectively communicate in writing.

If the IRS notifies you that they are going to conduct your examination through a personal interview, or you request an interview, you have the right to ask that the examination take place at a reasonable time and place that is convenient for both you and the IRS.

Preparing for an Audit

The best way to prepare for any IRS tax audit is to do a good job of record keeping during the tax year prior to filing your tax return. Then, if your tax return is selected for an IRS tax audit, the tax information needed to answer the IRS agent's questions will be at hand.

To get ready for an audit:

• Consult with a tax attorney or certified public accountant to understand the issues the IRS is focusing on
• Thoroughly review IRS Publication 1, the Taxpayers' Bill of Rights, which came with your audit notice
• Research the issues on the IRS Web site
• Discuss the situation with the professional tax preparer who helped you with the return in question, and decide whether he or she should be present with you in the audit
• Don't hesitate to ask for a postponement of the audit, if you're having trouble rounding up records

During the Audit

You may act on your own behalf at an audit or you may be represented or accompanied by an attorney, a certified public accountant, a person enrolled to practice before the IRS or the person who prepared the return and signed it as the preparer.

If you're going to be present during the audit:

• Do not volunteer tax information not requested by the IRS
• Bring all the documentation relevant to the tax item(s) in question, so that the evidence needed to support your tax case is available
• Bring documentation only for tax items specified in the IRS tax audit notice
• Organize the papers according to the tax items in question, and make copies of them
• Bring relevant worksheets to show how the tax figures in question were calculated
• Answer questions as concisely as possible
• Don't lie
• If you sense things aren't going well, don't hesitate to stop the audit so that you can consult with a tax attorney or accountant before continuing
• Ask to speak with the audit agent's supervisor if you think the agent isn't being fair

At the end of the IRS tax audit, the IRS agent will cite any problems with the tax return. After the IRS agent informally advises you of any tax adjustments needed on your tax return, a formal report is filed. The IRS must complete an audit and give you an examination report within three years of the time you filed the return.

Appealing Audit Results

Most people come out of an audit owing something. But what can you do when you can't live with the tax bill you get after an audit?

• Meet with the auditor or the auditor's supervisor to discuss the process and results, and see if they're willing to bend a bit to avoid an appeal
• Appeal the audit results to the IRS Appeals Office
• Take an appeal in Tax Court

Appealing your case within the IRS or to Tax Court will often net you some savings (although seldom a complete victory) and buy you time to figure out how you'll pay the ultimate tax bill.

Unfortunately, interest continues to build on the amount owed while you're appealing, and an appeal within the IRS may uncover issues not spotted by the initial auditor.

Instructions for appealing an audit result should come with the examination report, but you can also find this information at your local IRS office.

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