The Best Way to Prepare for an IRS Audit is to Keep Your Financial Life in Order by Sarah Gaymon, CPA
Posted on September 06, 2023
The best remedy for an audit is to be prepared for one before the audit letter arrives. Tax-planning decisions should never be made based on the likelihood of a potential IRS audit; however, you can set yourself up for success if an audit occurs. Following are 10 tips to help you keep your financial life in order, protect you from running afoul of U.S. tax laws, and support your position under an IRS audit.
Keep Contemporaneous Records
It’s much easier to document the facts now, while the facts are real, instead of going back and recreating them when you need the records. Accordingly, the best time to clean up your financial records, organizational charts and other documents supporting your personal and business activities is before the IRS comes knocking on your door. The more organized and accurate your records, the better prepared you will be to respond to an IRS examination notice. Keeping clear and contemporaneous records of foreign assets, business interests and incomes, related-entity information (including trusts and businesses co-owned by family members), charitable contributions and inheritances details will be helpful to have if the IRS ultimately pulls your tax return for an audit.
You should keep all the documentation related to your tax return for at least three years, but seven years is ideal.
Know the Loss Deductibility Rules Relevant to Your Business
U.S. tax laws have different rules dictating which taxpayers may deduct losses against different items of income based on parameters that include the types of activities the taxpayer performs and the number of hours the taxpayer worked on those activities. For real estate professionals, keeping track of hours spent in each activity and understanding certain aggregation elections may allow for the deduction of related losses.
When activities do not satisfy the criteria of a trade or business, taxpayers may not use losses incurred from those activities to reduce or offset other sources of income, nor may they claim deductions for all the expenses they incur from those activities. These are commonly known as hobby losses.
If you have hobby losses, the law provides a safe harbor you may apply to create a presumption that your activities are endeavored for profit. More specifically, 1) the gross income derived from the activity for three or more of the taxable years in a period of five consecutive taxable years exceeds the deductions attributable to the activity, or 2) the activity consists in major part of the breeding, training, showing, or racing of horses, and the income from those activities exceeds the deductions in two or more of the taxable years in a period of seven consecutive taxable years.
Be Prepared to Support Deductions for Business Meals and Entertainment
There are several conditions you must meet to claim deductions for business meals and entertainment. Not only must these activities include business discussions, but you should also be prepared with documentation of who incurred those costs, where and when the meal or entertainment took place, and how those activities qualify as deductible business expenses.
Be Careful with Travel and Car Use
It is common for the lines to blur between business and personal use of vehicles and travel for business and personal purposes. You may use your car during the work week to drive to client meetings and spend the weekend taking road trips with your family. Or you may travel out of state for a business conference and decide to spend an extra day or two seeing the sights. In both instances, you must maintain meticulous records documenting business travel time separately from personal and ensure you claim deductions only for business use. If you are using a personal car, keeping track of mileage in real time can support the business miles driven. There are apps available to help with this nuance, should you need it.
Know the Rules for Tax Residency
U.S. tax laws have specific rules for determining when foreign persons are considered U.S. tax residents. Similarly, states have rules for when a person should be treated as a tax resident of one state rather than another. While you do not need to memorize all the rules, you should, at a minimum, keep track of the number of days you are in the U.S. or in a particular U.S. state to avoid unintentionally falling under the country or a particular state’s tax jurisdiction.
Keep an Eye on Foreign Filing Requirements
There are so many forms U.S. taxpayers must file when they have foreign investments, own foreign assets or receive money from foreign sources; it is easy to forget one or two. To ensure you are not penalized for a failure to file, work with your tax advisor to identify all your foreign holdings and help you determine when a filing obligation exists.
On the first page of your 2022 federal income tax return is a question that asks if “at any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?” While you may not know if your ownership or use of cryptocurrency qualifies as a taxable event, failing to answer this question is enough to flag an audit. Check with your tax advisor to ensure you respond correctly.
Be an Active Participant in the Preparation of Your Tax Return
When your accountant provides you with copies of your tax return, do not automatically sign them. Instead, take the time to review the information, confirm the facts and ask questions if there is something you do not understand. Once you sign the tax return, you are saying that you agree to the information contained within it and are then liable for any accidental or intentional misstatements of facts,
Keep Copies of Records
As previously noted, keep copies of your tax returns for up to seven years to meet the IRS’s statute of limitations. However, there are certain documents you should retain for a longer period, such as gift tax filings, which you should keep permanently.
Communicate and Collaborate with your Trusted Advisors
Anytime your circumstances change, such as getting married, having a child, changing jobs or receiving an inheritance, it is critical you inform your tax advisor and possibly your attorney. Keeping these lines of communication open will help ensure you are prepared for an audit, you maintain tax efficiency, and your plans continue to meet your ultimate personal and business goals.
About the Author: Sarah Gaymon, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where she works with entrepreneurs and high-net-worth families to plan for tax-efficient wealth preservation and multi-generational wealth transfers. She can be reached at the CPA firm’s West Palm Beach, Fla., office at (561) 361-2050 or firstname.lastname@example.org.