The odds of being audited by the IRS are on the rise, thanks to dwindling tax revenues and stepped-up enforcement efforts. The IRS increased the number of returns it audited by nearly 11 percent in 2010, according to The Associated Press.
Fortunately, thorough recordkeeping will help prepare you in the event of an audit and protect your business from potential penalties.
Audits can be stressful, so follow these four steps to protect your business from the scrutiny of Uncle Sam:
1. Track expenses.
Keep annual summaries of income and expenses used to prepare each return, as this would be the starting point for the auditor. Also, back up your returns with receipts, bank statements, invoices that are stamped "paid" and other evidence of income and expenses.
“All expenses should be [paid] through a business account, either via a check or debit card,” advises Vincenzo Villamena, a New York City-based CPA and founder of tax website OnlineTaxman.com. This will help you separate your business expenses from personal ones and minimize the mistakes you might make.
2. Take notes.
“If you're self-employed or you own a business, your real challenge is proving the business purpose of your expense,” notes Dominique Molina, president of American Institute of Certified Tax Coaches in San Diego, and author of Breaking the Tax Code.
“The solution is to keep detailed written records, which you can do right in your regular appointment book,” Molina says. “This verifies deductions for car and truck expenses, meals and entertainment, and home office and business property use.”
That especially goes for anything unusual, says Meghan Blair-Valero, owner of Fogged In Bookkeeping in Nantucket, Mass. “If you buy a donkey for your advertising firm, you’d better make a note in the records of why, in case the purchaser is no longer with your business at the time of audit,” she says.
Take a second look and organize your records so they correlate with one another. “You have to be able to connect the money to paper records all the way through the cycle,” Blair-Valero stresses. “If I had $3,000 total deposits into my bank account and only reported $1,000 in income, I’d need to be able to prove that the other $2,000 was something other than income, or the IRS will tax me on it.”
Because you must keep the records used to prepare your returns for three years, protecting them is important. One option is to store them in plastic containers in a safe, dry area. But “digitizing and storing [them] electronically off site with a secure system and back-up [storage] is best,” Blair-Valero says.
Related Resource: 4 IRS Red Flags to Avoid