The IRS has a veritable army of tax examiners (they don’t like the word “auditor”) and collectors, numbering 31,000 in 2008 and projected to increase to over 37,000 within the next decade. And behind those examiners and collectors are tens of thousands of supervisors, appeals officers, lawyers and others supporting their work. Against this backdrop, you may feel that the best you can do to stay in good graces with the IRS is to simply hope you never get audited.

It is true that a very small percent of tax returns get audited: slightly under 1% for people making less than $200,000, slightly under 3% for people making between $200,000 and $1 million, and under 1% for most small businesses (with S corporations and partnerships being under 0.5%). But that doesn’t mean you should just cross your fingers and hope for the best. Those broad statistics include a lot of people for whom there is no reason the IRS would ever want to waste resources looking at their return; for instance, they receive a couple W-2s, some interest income, and don’t itemize. Assuming you don’t fall into that category, your chances of being audited could be substantially higher than the statistics show.

What should you do in order to have the best chances of surviving your audit relatively unscathed? Here are some tips:

• Document the nonfinancial things. Of course you know that you will have to support direct expenses with a paid invoice or receipt, but beyond that there is some additional record-keeping you might need to do.
  • Business usage of automobile – Where and when you went and for what business purpose. The IRS generally is not going to allow 100% business usage of an automobile without stellar documentation.
  • Participation in an activity – If you have rental properties or a side business, you should be keeping a log of what you do for the business and how long it takes you. Sometimes this documentation will prove that you have made certain active/material participation requirements that will allow you to claim losses from the activity.

• Issue Form 1099-MISC to non-employees. Too many businesses put themselves at risk by agreeing to not issue a 1099-MISC to an independent contractor. While it may be out of the kindness of your heart to play along with this game (for instance, the individual’s rent will increase because it is based on income), the IRS does not look too kindly on a business aiding another in the process of tax evasion. As such, the penalty can be that your business will effectively lose out on the deduction for those amounts that should have been reported on a 1099-MISC. You can end up paying the IRS 50% or more of the amount you paid the individual to whom you did not issue a 1099-MISC.

• Keep records of large sources of non-taxable bank deposits. In many audits of small businesses, the auditor will do a bank deposit analysis to try to determine if you are receiving income that is not being reported on your tax return. The general presumption by the IRS is that all deposits into your bank accounts are from taxable sources of income. You need to have information to show them otherwise if you are making deposits of funds received as a gift, loan, inheritance, repayment of a loan made to others, etc.

• Keep your corporate minutes and record book up-to-date. In the audit of a corporation, one of the first things the IRS always asks for are the corporate records. This is to ensure that the formalities of the corporate legal structure are being honored. If they are not, the IRS can potentially “pierce the corporate veil” and pursue the shareholders for any tax due by the corporation.

• Tell your accountant everything. It is tempting to say that what your accountant doesn’t know can’t hurt you, but without knowing everything we can’t help you either. We are your advocates within the confines of the law and our ethical obligations as professionals. For instance, if we go in to the initial interview with the auditor saying that all income has been reported on the tax return, only to have the bank deposit analysis later reveal regular deposits from your side business, then we end up with a credibility problem with the auditor. Not only will the auditor possibly dig deeper to try to find other problems with your tax return, but it also makes it more likely that discretionary penalties could be assessed against you if they feel you lied to them.