Managing an IRS Audit: What Contractors Need to Know

IRS audits are on the rise among trade business owners, and as someone who provides tax services to contractors, I know how important it is for them to understand the audit process.

Even though being invited to participate in an audit can sometimes strike fear in a business owner, remember that an audit is just one of the methods the IRS uses to verify the information taxpayers represent on their tax returns.

Unfortunately for contractors, construction is one of the industries that is most frequently audited by the IRS. These audits can be extensive and may require a lot of your time and money. It’s generally sound advice to hire an enrolled agent (authorized by the IRS) to represent you, instead of trying to represent yourself. More on that later, but let’s dive in at the beginning.

Winning an Audit

The best practices for winning an IRS audit include consistently documenting all business activity, keeping receipts of all transactions represented in the tax returns. But once an audit notification has been received, it will be more challenging to locate all of the necessary receipts and documentation. “Hindsight is 20/20” as they say; the lesson here is not to wait until the audit is in progress, because it might be too late.

When a contractor receives a letter from the IRS there are specific actions that must be taken in a timely way.

• Open the letter – This may seem very obvious, but in our experience, some contractors ignore notices from the IRS until they receive levies on their banks accounts and accounts receivables. At that point, they have missed the audit appointment date, missed the notice of the assessed liability, as well as the demand for payment, and notice of tax levy. They may also have forfeited some of their rights as taxpayers.

• Understand the scope of the audit. Audit notices will provide:

➢ The type of audit
➢ The issues being reviewed
➢ The documents requested
➢ The due date of the documents requested
➢ Instructions on how to provide the documentation to the IRS
➢ Your rights, including representation

Once the scope of the audit is understood, the contractors can then determine how to prepare for the audit: Who on their team is capable of being designated as a primary point of contact? Should a professional representative be engaged? How should they respond? Does the date and time of the audit provide sufficient time for them to comply with the request?

Types of Audit and Stages of an Audit

There are three types of audits of which contractors should be aware:

Correspondence – these audits are conducted by mail. The audit notification letter will direct the taxpayer as to how the documents requested can be submitted to the IRS: by mail, fax, and/or uploaded to the IRS portal.
Office audits – in this case, the audit takes place in-person at an IRS office.
Field audits – The audit is conducted at the contractor’s place of business.

Once the type of audit is clear, it generally proceeds in the following stages. 

Organize the requested records for items under review.

If income is one of the items under review, bank statements, and 1099s received from customers may be required. If expenses are to be reviewed, receipts for purchases/expenses will be required. Organizing the receipts by category and year can help the contractor verify expenses and identify any discrepancies as well as reduce the amount of time within which the audit will be completed.

Analyze the documentation.

Once all the relevant information has been compiled, the documentation must be analyzed in order to identify any discrepancies based on the audit items as well as to help predict any other discrepancies that might arise.

At this point in the process, if you haven’t already, we recommend hiring an enrolled agent who can conduct the documentation review and make the appropriate analysis. It is best to ensure the documentation substantiates the information stated in the tax return under audit. It is not uncommon for the IRS to expand the scope of the audit should the information stated in the tax return not match the initial set of documentation/receipts provided.

Do Not Meet with the IRS Alone.

Contractors can be tempted to represent themselves at an audit. In a contracting company, there may be an accountant who prepares the financial statements for the tax preparer. The contractor may have little or no idea what was stated on the tax return and the reason why there may be a discrepancy between the financial statements and the tax returns. For that reason the contractor may not be able to accurately respond to questions from the auditor.

With that said, hiring an enrolled agent to represent you with the IRS is typically an excellent solution. Items to be presented during the audit will be researched in advance by the agent, to ensure the nature of the discrepancies is fully understood, and who can, in turn, accurately communicate with the auditor.

Review the findings.

Once the audit is concluded, the IRS can close the audit in one of two ways: with “No Changes” or with “Proposed Changes”. The contractor (or their authorized representative) should review these changes carefully. If they do not agree to the changes, they have the right to appeal the outcome of the audit.

Again, it is important to open any follow-up correspondence from the IRS as soon as it is received—and subsequently take whatever action is necessary (an appeal or an agreement to the terms) to ensure their rights are protected.

Final Notes

While audits cannot be prevented, a contractor can make the process less stressful in terms of how it is handled.

It’s important to be aware that an audit may not be a result of wrongdoing; for example, it could be that the disputed amount(s) reflected a particular category out of the industry standard; or the entire audit might be just a part of the IRS’s compliance program. Either way, once a contractor can prove the items in question are for business purposes and can produce the documentation to validate the amounts, the audit can be won.

With proper representation on the contractor’s behalf, either by an enrolled agent or other authorized representative, there are increased odds of a favorable outcome.