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Types of Audits

Tax season has just ended. You can breathe a sigh of relief that you’ve met the deadline. But what do you think of when you hear the word “audit”?

Like most people, you probably start thinking of being notified by the IRS that your finances are coming under closer scrutiny, and no small business owner wants to hear that. But an IRS audit is just one type of audit. As a general definition, an audit is an investigation and it can be of a system, report, or entity. Businesses will encounter several types of audits.

Operational Audits: This type of audit takes a look at the company’s goals, processes, and procedures in relation to the results a business has had. This can be conducted internally or externally and may result in recommendations for improvement in some areas.

Compliance Audits: If your business is in a regulated industry, a compliance audit reviews whether or not the company adheres to the specified regulatory guidelines. These can and should be performed by the employees of the organization or organizational representatives to ensure the company’s ongoing compliance and correct any deficiencies that are found. Also, external compliance audits may be conducted by auditors assigned by a particular regulatory agency. 

Financial Audits: Financial audits conducted by an independent examiner outside of the business, typically a CPA firm. It is used to determine the accuracy and fairness of the company’s financial records for a specific period of time and based on Generally Accepted Accounting Principles (GAAP). There are several benefits to having a financial audit:

  • Peace of mind for the CEO or owner that there is no fraud or wrong doing occurring within the company.

  • Audited financial records may be required by banks if you are applying for loans or by other third party investors.

  • If you are planning to sell your company in the future, audited financial statements make your company more attractive to potential buyers.

State and Local Tax Audits: State and local tax compliance can be complicated. Not only is tax due on business income, there are also state and local sales taxes that must be remitted. You may have to file in multiple jurisdictions. Failure to do so can cause state and local officials to take a closer look at the company’s financial records to be sure that the proper amount is being paid.

Federal Tax Audit: And finally, we will discuss the dreaded IRS tax audit. An IRS audit examines the company’s accounts and financial information to be sure that it is reported accurately according to tax laws and that the proper amount of tax has been paid. Keep in mind, if you are being audited by the IRS, you will receive a notice in the mail, not by phone or email.  There are several types of audit notices that you may receive from the IRS.

  • Letter with notation of CP-2000: While not technically considered an audit, this is a question requiring more information be provided about an item on the return. For example, if you are an independent contractor perhaps there has been income report to the IRS on Form 1099-MISC that you have not reported on your income tax form. Usually you can pay any applicable taxes if you agree or explain or contest the amount.

  • Letter with notation of Form 566(CG): This is typically known as a correspondence audit. The IRS may be looking specifically at a deduction that was made and is looking for the taxpayer to provide proof such as a canceled check, invoice or credit card statement to support the deduction.

  • Letter with notation of Form 3572 for audit at IRS office: Also known as a regular or office audit, you and/or your representative need to appear for a specific appointment at a designated location by the IRS to review specific items on the return. It is highly recommended that you have a tax expert with you. They will ensure that the questioning remains limited to the items that were initially raised and that no information is given that could potentially expand their inquiry.

  • Letter with notation of Form 3572 for field audit: In the event of a field audit you will definitely need to be represented by a tax expert. Field audits are complicated and intrusive. The IRS agent in addition to reviewing the tax records for a particular year may also interview employees regarding business operations and examine equipment. The IRS will have 28 months to complete the audit from the date the return was filed or the date it was due, whichever is later.

Of course, preparation and accurate record keeping is the best defense if you are audited. Being proactive and keeping detailed and organized tax records is much better than being reactive and having to gather your documents after receiving notice of an audit. 

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