What is an Audit?

An audit is defined as a methodical examination. Audits are grouped into two principal sets – financial and organizational compliance (usually related to licensure). For the small business entrepreneur, it is almost unheard of for them to have an organizational compliance audit. Small business audits are almost entirely financial in nature. Within the financial audit group, there are several types of audits. More than 80% of small business audits are related to tax compliance. It is more likely that the small business will be audited by the local government or the state’s department of taxation in relation to sales tax collection than an Internal Revenue Service (IRS) audit. 

The following sections describe the three most likely financial tax audits for a small business. Each is illustrated and explains what the small business owner should expect. It also explains the importance of maintaining control over the documents and assets of the company.

Local Government

The local government raises revenue from businesses from two distinct sources. The first is the local revenue tax, also referred to as the business license tax, and the second source is personal property tax assessed against the business. Most local governments use a commissioner of revenue to assess and collect the tax. Within their office structure are examiners who select certain businesses for audits. A notice is sent to the owner and typically the examiner goes onsite to conduct the audit.  

For the small business owner, this is a chance to show pride in your business operation. It is also an opportunity to teach the examiner about your business. Remember, these examiners live and buy in your town. They are the guy down the street. It is important to have a cordial relationship. The examiner is there to confirm existence of the assets you reported and to identify any personal property that you may have overlooked or did not include in the report. 

As it relates to the revenue tax, they review your tax return to verify sales and then review your accounting entries to break out the income into the respective license groups. It is not uncommon for a business to have two or more licenses. As an example a veterinarian business will have a professional services license, a kennel/storage license, and/or a retail sales license (collars, special medical aids etc.). The examiner is interested in how you determined the revenues for each of the license groups. A typical encounter with an examiner at this level is about an hour to two depending on the size and location of your operation. I have experienced about two dozen of these types of audits for clients, every one of them was a pleasant encounter and there were rarely any discrepancies. 

If you need more guidance or understanding, please read The Local Revenue Tax.

State Department of Taxation

Of all the financial tax audits, this is the most likely audit that a small business owner will incur. Actually, you’ll get this type of audit several times over the course of business operations. The typical state has a significant portion of its tax revenues sourced from sales tax. Therefore, it is important to verify compliance. The more retail oriented your operation is, the more likely you’ll receive this type of an audit. 

It is the responsibility of the consumer to pay the sales tax associated with the items they purchase. Each state is different it what is taxed and what is exempted from the sales tax. Most states exclude medications, certain foods, and fuel (gasoline does not have a sales tax, but a fuel tax in most states; it is a per gallon type of tax and not based on dollar sales).

It is the responsibility of the seller to collect the sales tax and transfer this tax to the state tax department (sometimes called the revenue department). Most states use a monthly reporting format and payment transfer. 

Most states send an auditor to the place of business to inspect the system used by the business to verify that the system (retail program, accounting program, product taxation format) is set up correctly to collect the correct amount of tax. Many states use a tier taxation system. As an example, if a contractor does repair at a residence, only those line items on the invoice associated with a material good sold to the consumer is taxed. Any labor related line items are exempt from the tax. The auditor is confirming that the contractor separates the two different forms of provided service to ensure correct calculation of the tax. The examiner often samples invoices or transactions over a period of time and then extrapolates to determine the volume of taxable sales. If that volume dollar figure is within a certain percentage, about 3% of the actual reported amount, the auditor considers the business to be in compliance. If out of range, the small business owner is allowed a period of time (usually 4 – 6 weeks) to demonstrate compliance for the period under audit. The small business owner has to provide substantial evidence through more examples of compliance with the law.

I have participated in about two dozen of these audits. Some were done in less than two hours because the volume of activity is low; others have taken a week to complete. Those that are extended in nature are due to the high level of complexity of the business operation under review. The business sells more than just one or two items, but sells not only retail, but provides services and repair parts along with the sale of warranties, large ticket items (jewelry, boats, RV’s, auto’s, farm equipment), and offsite services. 

Once the audit is completed and if the state determines the business to be out of compliance, they will assess the business a tax and a penalty. Along with this tax/penalty is interest. Here the taxpayer should not fret; it is possible to negotiate a settlement with the department of taxation. I have actually negotiated three of these. The tax department isn’t interested in going through each and every sales ticket for the period under audit and the taxpayer is interested in moving along. The department of taxation (revenue) is interested in the business getting into conformance with the law and collecting the correct amount of tax. It is important for the business to have been in timely compliance in the past (proper filing of returns in a timely manner and paying the tax on time). This demonstrates to the government a willingness to be a good citizen and often bodes well for the business if negotiations occur.

Another type of state audit is the employment commission audit. Here the commission reviews your payroll accounting to ensure that the reports and tax are filed quarterly. Usually the small business takes their documents for the payroll quarter under review to the local commission office and the actual information is matched against the reported information. There are rarely any discrepancies with the exception of the owner himself. Many states allow the business owner to exempt himself from the tax. Talk with your CPA about this issue.

There are some myths out there for sales tax. The most commonly stated myth is that non-profit organizations are tax free. Yes, but only income tax and FUTA tax. They are not tax free as it relates to property taxes or sales taxes. If they consume the final product (office supplies, materials, etc.) they must pay the tax. Each state is different, but to my knowledge I know of no state exempting non-profit organizations from the sales tax.  For a better understanding about non-profit taxation, please read The 501(c)3 Organization.

Internal Revenue Service

Of all the audits, this is the one most feared by small business owners. The fear is derived by the power the Internal Revenue Service has over the property of not only the business but the owner of the business. The IRS has the ability to place a lien on the assets of the business for failure to comply with the law. In 90% of all audits, the primary tax under review is the employment tax. These are the income, Social Security, and Medicare taxes withheld from the paychecks of the employees and the corresponding matching taxes paid by the employer. As long as the small business owner files the returns in a timely manner and pays the taxes accordingly, there is rarely an issue in this type of an IRS audit. For more help and guidance see the following articles:

• Form 941 Basics
• An Explanation of FUTA
• The 1099 Subcontractor

In some IRS audits, the entire business operation is under examination. The IRS sends out an agent to the place of business. His job is to ensure proper documentation of expenses, confirming that the expenses are deductible, all revenue is recorded correctly and that the return is filed in an appropriate format. It is actually abnormal for the business to be out of compliance unless the entire front office operation is void of organization. I have yet to witness this, but agents have informed me of walking into businesses and even the owner has no clue where to find information. When they observe this type of business management, the agent is already predisposed to come down hard on the business. The Federal Code and Regulations specifically state the need to have adequate and proper supporting evidence for a deduction. In addition, it is the responsibility of the owner to safeguard the process of recording revenues. The agent looks for the internal controls used by the business to ensure that revenue is recorded correctly. The best defense against an IRS audit is a well-organized office. Read A Proper File Structure for Accounting for guidance on this subject.

If the front office has proper organization and there are adequate internal controls to monitor revenue and expenses, the auditor then reviews the typical non-deductible expenses that most small business owners take as a deduction. These include the following:

1.  Life and other insurances for the benefit of the owner
2.  Transportation expenses, specifically those related to the owner
3.  Excessive meals and entertainment costs (travel to exotic places, Las Vegas etc.)
4.  Personal expenses specifically those related to the owner
5.  Credit card expenses improperly documented

Notice how the agent is keying in those items related to the owner of the business. He is vouching for the ability of the business to separate the business expenses from the personal expenses of the owner. A good file structure and attention to the owner’s expenses can indeed prevent this issue from arising in an audit.

Summary – Audit

In general, financial audits by government serve the society well by helping to ensure tax compliance.  If a business operation underpays the tax, this underpayment burdens the rest of the community and is shared by all.  The small business owner can demonstrate full compliance with  a proper filing system, document management system, a good accounting program, filing tax reports timely, paying all taxes on time and by paying attention to the local, state, and federal tax laws. If you have any questions, please e-mail me at dave(use the standard ‘AT’ symbol)businessecon.org. Act on Knowledge.

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