Prepare Early to Successfully Manage a Tax Audit: Part II

Published By Otto S. Shill, III

Prepare Early to Successfully Manage a Tax Audit: Part II

This is Part II of a three-part blog focused on how business owners and managers can successfully prepare for and manage a tax audit. Part I discussed the need for business owners and managers to understand the financial details of the business.

This blog focuses on the second area: Why owners and managers should actively participate in decisions concerning how financial results are reported to government agencies.

It is critical that owners and managers understand financial and tax reporting. Many business owners believe that if their accountant prepares their tax return, it must be correct. Most accountants work very hard to accurately reflect the financial results of the business; however, accountants base their work on the financial information they receive from their clients. It is common for an accountant to prepare an income tax return based on the accounting system information he or she receives from the business owner or manager without ever receiving backup documentation. If the business’ accounting system is inaccurate, the return will be as well. Sometimes accountants receive unorganized documentation and receipts without a formal accounting system, requiring the accountant to do the basic data entry and make decisions about how items of income and expense should be characterized.

Even with the help of a competent accountant, it is the business and the business owner, not the accountant, who is responsible for the accuracy of the information reported on a tax return. Every person who signs a tax return as a business owner makes the following representation:

Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete. 

A business owner’s signature on a tax return is that owner’s representation to the government about the financial performance and tax liabilities of his or her business. That owner expressly states that he or she has read the return and its schedules, and that they are true and correct. In other words, the government will expect that the business owner understands both the reporting positions taken on a return and the transactions and documents upon which that position is based.

Many business owners rely on their accountants or attorneys for guidance on how to structure transactions and whether applicable law supports the reporting position; however, it is the responsibility of the owner who signs the return to understand the issues, transactions and justification for the reporting position taken. Therefore, to the extent that the law is uncertain with respect to the position, the risks associated with the reporting position should be no surprise at audit time. Business owners and managers should understand the economic impact of the transaction and why a particular reporting position about the transaction makes sense in the context of the business deal. In the end, the knowledge necessary to make the required representations to the government about the tax return is the same knowledge that empowers a business owners and/or managers to successfully respond to an auditor’s questions. It also empowers business owners and managers to arm their professional advisors with the information needed to effectively advocate in favor of the position taken on the tax return, or to reach a resolution of the issues.

In addition to understanding the financial and tax reporting aspects of their businesses, business owners should ensure that it is organized and filed in a way that allows an auditor to easily verify reported income or expenses against source documents. In general, the goal of audits is to verify that what a business has reported is permitted by law. The auditor’s first step in that analysis will be to verify the numerical values reported against source documents. Businesses that organize and store accounting records in a way that is similar to the way the information is organized on the tax return will spend far less staff and professional time to prove the basic numerical facts reported in the return. When business or financial reporting requirements dictate a different method of organization, a map outlining how financial accounting categories and the organization relates to the tax return can save time and money.

In the end, a business owner who understands the business’ financial and tax reporting positions and who retains source documents in a way that allows efficient verification of reported amounts will reduce costs and may shorten audit times. Part III of this article, which will be posted next week, will provide guidance on how to work with attorneys and accountants effectively to prepare for and manage a tax audit.