What does a tax audit actually examine?

A tax audit checks financial records against the information reported on a tax return. The IRS describes its purpose as verifying the return and the reported tax amount. IRS audit guidance.

For preparation, think in terms of a traceable transaction. Choose a reported expense and ask: what was purchased, where is the supplier document, how was it paid and where was it recorded? Write down anything you cannot yet explain.

Separate selection from preparation

The IRS says selection can involve random sampling, computer screening or transactions connected to another taxpayer under examination. Being selected does not necessarily mean something is wrong. IRS selection methods.

Spend your preparation time on the questions in the notice. Avoid guessing which purchase attracted attention. Give your accountant the records and a plain description of the business activity behind them.

For a broader habit of identifying problems and assigning responsibility, use the small business risk management guide.

What should you do when the notice arrives?

Read the entire notice before gathering documents. The IRS initiates audits by mail and provides contact information and instructions in its letter. IRS notification process.

• Record the tax year or period being examined.
• Copy each information request into a working checklist.
• Enter the response deadline in your calendar.
• Identify the requested delivery method.
• Assign someone to collect records and someone to review them.

Create one place for correspondence

Save the notice, subsequent letters, your questions and submitted responses together. Keep the original files separately from working notes. Give each request a number and use that number when naming the supporting files.

If a request is unclear, write a precise question for the contact identified in the notice. For example: “Does this item concern the full year or the listed transaction?” Keep a dated note of the answer.

If you expect a delay, raise it early and check the applicable procedure with your adviser. Do not plan around an extension you have not established applies to your case.

Which records should go into your response file?

Use the actual request as your document list. The IRS provides a written request specifying what it wants to examine. IRS document requests.

The table below is a suggested collection worksheet, not a universal list of mandatory submissions. Ask your accountant which rows apply to the issues being reviewed.

Add a document index

An index is simply a list showing where each document lives. Use columns for request number, filename, period, owner and status. Mark an item “ready” only after someone opens it and checks that it contains the expected information.

For a missing invoice, record who will contact the supplier and when. Keep the replacement document with that request. Do not fill gaps with invented descriptions or reconstructed figures presented as original records.

Before handing work to a bookkeeper, agree what they will collect and what your accountant will review. The guide to delegating business tasks offers a structure for that handover.

How do you check that the figures make sense?

Reconcile the relevant records: compare them and explain the differences. The SBA, the U.S. Small Business Administration, includes bank reconciliation among the financial tasks a business should have someone manage. SBA financial management guidance.

1. Start with the amount shown on the return.
2. Identify the calculation supporting that amount.
3. Connect the calculation to individual entries.
4. Attach the relevant documents.
5. List unresolved differences for your accountant.

Hypothetical example: an online homeware shop

Imagine the shop's order report and bank deposits show different totals. Make separate lines for sales, refunds, payment fees and settlement dates. Investigate each difference instead of changing the sales figure until it matches the bank.

If you suspect a fee explains a difference, find the corresponding statement. If evidence is missing, label the explanation as unresolved. Ask your accountant how to treat the item before changing the books or a filed return.

Also confirm the accounting method used. SBA distinguishes recording income when payment arrives from recording it when the sale occurs. Check timing differences against your own method. SBA explanation of accounting methods.

Keep this review separate from forecasting future cash. You can build that routine with the small business cash flow guide.

How long should you keep records, and in what form?

For U.S. taxpayers, the IRS audit page states that records used to prepare a return must be retained for at least three years from filing. Treat that as a minimum described by this source, not permission to delete every business record after three years. IRS recordkeeping guidance.

Ask your accountant to create a retention schedule by document type. Include the applicable rule, the event from which the period runs and who authorizes disposal. Keep records connected to an unresolved matter pending specific advice.

Make the archive usable

Organize folders by business, year and record category. Choose a consistent filename containing the date, counterparty and document reference. Keep a readable copy alongside any original export needed to understand the data.

• Restrict access to people who need the records.
• Store a separate backup.
• Test opening a few files from that backup.
• Record the location of paper originals.
• Review disposal decisions before deleting anything.

The IRS accepts some electronic records, but asks taxpayers to confirm acceptable formats with the auditor. Check that before preparing a large submission. IRS electronic record guidance.

Use Excel, Google Sheets or your existing accounting system for the index. Before buying another tool, test whether a colleague can locate a requested record using your current setup.

What should your preparation week look like?

Organize the week around completed pieces of work. Adjust this suggested schedule to the actual deadline and the volume of records.

1. Day one: read the notice with your adviser and create the request checklist.
2. Day two: gather documents, build the index and identify missing items.
3. Day three: reconcile the relevant figures and write down questions.
4. Day four: review explanations and follow up on missing evidence.
5. Day five: check the response package and arrange submission.

Review the package as the recipient would

Follow the request order. Open every attachment, check page completeness and confirm that each explanation points to the correct document. Keep a copy of exactly what you submit.

Arrange confirmation of receipt. The IRS expressly recommends obtaining confirmation that it received your response. IRS delivery guidance.

After submission, turn recurring preparation steps into a routine. Write down who saves documents, who checks totals and how missing records are followed up. Use the standard operating procedure guide to document it.

For your own review meeting, ask your accountant to walk through the figures you found hardest to explain. The guide to reading financial statements can support that conversation.