Don’t Panic: How to Prepare for an IRS Audit
No one likes to receive a notice from the IRS that they are being audited, including law firms. But if you receive a notice from the IRS, don’t panic. The best defense is to be prepared.
How your firm is selected
The IRS trains examiners to specialize in particular market segments through its Market Segment Specialization Program. This means that examiners assigned to your case are familiar with legal industry issues, practices and terminology. Typically, as they have audited firms, they have honed their skills and will know which questions to ask and records to examine to expedite the audit process.
To identify potential tax issues, the IRS uses the discriminant index function (DIF) point system. Activities, such as handling large amounts of cash, can raise a firm’s DIF score and its odds of being audited. And, some specialties attract more attention than others. Real estate lawyers, for example, are a common IRS target because they may take a property interest in a transaction and fail to report it.
What to do to prepare
Obviously, your best strategy for dealing with the IRS is to avoid an audit in the first place. Protect your firm by working with experienced tax professionals and have partners sign statements annually verifying they have filed their returns.
Maintaining good records is also critical. Examiners tend to be more lenient when firms being audited have thorough records that include accounting documents, updated cash-receipt and cash-disbursement information and completed time records and journals. Examiners are particularly interested in money borrowed from clients that is later forgiven for services provided.
The IRS will look at each partner’s partnership or limited liability company (LLC) interests or stock received in lieu of cash for services provided. To avoid potential problems, be sure your firm’s attorneys document and report such transactions.
When the audit occurs
The first step you should take if you do receive an audit letter from the IRS is to call your CPA. This individual will likely instruct you to respond promptly and may be able to help you delay or even avoid the need for interviews. Often, the IRS simply needs to clarify a detail. If you delay your response or ignore the IRS, it may raise suspicions about your intentions.
What if the IRS asks to meet with you? Arrange to meet at the auditor’s or your accountant’s office. Meeting at your firm’s office can give the auditor an opportunity to compare your surroundings to the income stated on the return and may raise red flags, even if they are unwarranted.
Keep in mind that the IRS will look at a particular item only a finite number of times, so be sure to point out any previously audited items. For example, if an auditor examined the same entry (such as mixed automobile use for business and pleasure) in the past two years and made no change, your CPA may be able to persuade the current auditor to bypass this part.
One of the most important things you can do when the IRS comes calling is to remain professional throughout the entire process. If a dispute arises and you are unhappy with the result, have your accountant, who is more likely to approach the situation with a cooler head, handle it. If necessary, your accountant can request a meeting with the auditor’s supervisor or a district supervisor.
Avoiding litigation is your best course of action. However, if needed, you can file an appeal with the IRS’ local appeals office. Note, however, that the IRS wins the majority of these cases, and appealing a court decision typically costs more than paying the tax.
Don’t get hurt
The odds of getting audited were less than 1% for fiscal year 2017 (the latest numbers available). So while the chances are slim that you will be one of the unlucky ones, it pays to be prepared. And remember, most likely the IRS is looking to clarify a discrepancy and does not intend a protracted audit.
For more information, contact Rob Swenson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Law Firm Group.