Each year, the Internal Revenue Service (IRS) conducts audits on individuals and businesses to ensure that they are in compliance with U.S. tax law. The percentage of people and businesses subject to these audits is relatively small—in 1996, for instance, the IRS audited only 1 percent of tax returns filed by partnerships, 2.3 percent of returns filed by corporations, and 4 percent of individual returns—but the prospect of being targeted does provoke dread among a certain portion of the American public.

Indeed, many business analysts believe that smaller businesses in certain industries are at greater risk of being subjected to an audit because of historically higher levels of noncompliance in those industries, many of which are primarily composed of small firms. Home-based businesses that are characterized by cash-based transactions are particularly likely to undergo formal IRS review. Many business and tax experts, however, contend that small businesses that conduct their operations honestly and maintain good recordkeeping practices should be able to weather an IRS audit without too much difficulty. Indeed, some small business owners have been known to actually request an audit in instances where they have a dispute with the IRS over tax obligations.

When providing advice on IRS audits, tax advisors counsel small business owners to adhere to the following guidelines:

* Be honest in business operations and in claiming deductions.
* If you prepare your own returns, be familiar with IRS rules regarding deductions and other tax matters; if not, make certain that you hire an accountant or tax advisor who is knowledgeable in these areas.
* Keep all receipts and maintain sound and thorough record keeping practices.
* Keep expenses in line with industry norms.
* Make sure that the auditing agent is knowledgeable about the industry in which you operate.
* Be cooperative; promptly answer all communications from the IRS and make every effort to provide the auditing agent with all requested information.
* If you are unhappy with the results of an IRS audit, consider making a written appeal; the Internal Revenue service maintains an independent division specifically designed to hear such appeals.


As the Internal Revenue Service goes about the annual routine of gathering and processing tax statements from businesses and individuals, one of the agency's principal responsibilities is to be on the lookout for cases of potential tax evasion or fraud. Business experts cite several primary scenarios that are likely to prompt further investigation:

* Accounting irregularities, such as discrepancies between amounts reported on various financial statements.
* Inadequate recordkeeping, such as missing or incomplete financial records.
* Failure to report all income.
* Improper claims for deductions (such as in-flated claims of business costs).
* Allocation of income to related taxpayers, especially if the recipient pays lower taxes.

Financial Status Audit. One of the primary means by which the IRS conducts audits is the financial status audit. Under this form of audit, the investigating agent compares the amount of income reported against the assets and lifestyle of the taxpayer. The visibility of this type of audit has fluctuated in recent years, however. In fact, the financial status audit became a lightning rod for criticism of the IRS in the mid-1990s, when the agency announced that it intended to provide increased training in this area in order to increase its use of this type of audit. Resistance to this focus was strong and immediate. "Many practitioners and the AICPA [Association of Independent Certified Public Accountants] were concerned about the intrusive nature of these audits and the alarming rate at which they were being performed, " claimed Philip Fink and Charles Gibson in CPA Journal. "There was great concern that this type of audit was being performed when there was not a perceived need for it. Many CPAs thought the use of the financial status audit presumed a suspicion on the part of the examiner that the tax return had been prepared fraudulently and recognized that an attorney's services would therefore by required." The adverse reaction to the IRS decision reached a culmination in 1998, when the IRS Restructuring and Reform Act of 1998 was passed into law. This legislation placed limits on the use of the financial status audit, although it did not put an end to them.


The Market Segment Specialization Program, established in 1992, is an IRS initiative designed to conduct and analyze in-depth studies and actual audits of industries with unique business practices. MSSP Audit Technique Guides aim to improve the auditing process by creating and distributing auditor training guides on these specific industries. These guides, which were originally developed for reference use by auditors and IRS revenue agents, can also be useful to businesses preparing for IRS audits or researching their tax liability. Each of the available guides—which cover industries ranging from air charter services and architectural firms to mortuaries and gas retailers—include an overview of industry issues, outlines of the books and records that may be maintained for tax purposes, examination techniques, industry terminology, and highlights of the prevailing business practices in that industry. All MSSP Audit Technique Guides are available through the U.S. Government Printing Office.

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