Turn to technology to make tax audits less painful

As 2023 comes into view, the specter of 87,000 new Internal Revenue Service employees has gotten the attention of accountants and bookkeepers — as well as small and midsized business owners. 

This follows the Inflation Reduction Act of 2022, flagship legislation that provides nearly $80 billion to replenish the workforce the IRS had lost to attrition over much of the previous decade. Those who produced the legislation claim that not every one of those employees will be put to work on audits. But more than half of the money — $45.6 billion — has been earmarked for enforcement: identifying who owes taxes and action to collect what's owed, as well as legal support and criminal investigations. The IRS commissioner has the discretion to determine how to direct these activities.

That worries SMBs and the people who serve them, including accountants. Small Business and Entrepreneurship Council president and CEO Karen Kerrigan is among the most vocal. She has said she sees that small businesses "of moderate means" most frequently find themselves in the crosshairs of the IRS. Worse, the additional cost to defend an IRS audit can be more of a blow to smaller businesses than large corporations, which keep lawyers and accountants on payroll and retainer. Congress' Joint Committee on Taxation believes small businesses with less than a $200,000 annual income, will wind up generating 78% to 90% of the estimated additional $200 billion the IRS will collect.

In addition, the IRS gained more leeway with the 2017 Tax Cuts and Jobs Act, which makes it possible for the IRS to handle "pass-through" entities (limited liability companies, partnerships, S corporations and sole proprietorships) differently than they would a large corporation. The Tax Cuts and Jobs Act allows the IRS to determine which small businesses can receive a "qualified business deduction." It's not unreasonable to wonder if a larger IRS workforce with a directive to focus on enforcement will choose to offer that qualified business deduction. 

Getting stuck holding the audit ball

Former IRS Commissioner Charles Rettig has said, "These resources are absolutely not about increasing audit scrutiny on small businesses or middle-income Americans." He did, however, mention "pass-through entities and multinational taxpayers with international tax issues."

Whether or not the new IRS employees will focus enforcement on small businesses or large corporate and global high-net-worth taxpayers, there's every reason to expect there will be more need for accountants and their clients to prepare for audits. The IRS believes it is making up for decades of diminished ability to hold taxpayers accountable, and whomever it audits had best have their financial houses in order. 

But smaller businesses, pass-through entities and individual taxpayers are the most likely to have bookkeeping gaps and flaws that will render them more susceptible to a negative tax audit. These folks aren't purposefully misstating their finances. They're just too busy, understaffed and cash-strapped to make bookkeeping and accounting a key part of their processes and procedures. They provide imprecise spreadsheets, random email receipts, and/or shoeboxes crammed with purchases and revenue documentation, expecting their accountants to make sense of it all and prepare it for the IRS with a bow on top.

More frequent tax audits will drive more businesses to accountants. Some may even do so for the first time, making it even less likely that the tax preparation professional will be familiar with the account. Certainly, compensation will be part of the deal — and the more gnarly the books and tax filings are, the more billable hours — but few accounting firms serving smaller businesses and individuals have the administrative resources or desire to wade through mountains of financial documents. Missing and misplaced receipts, revenue not properly deposited or correctly applied to asset accounts, inventory recorded as one big asset and not broken out by project or type — these all could be in your future as you sit across from a fresh IRS employee hoping to prove their worth.

What to do

Reach out now to current clients (if you haven't done so already) and advise them to button down their business practices. Imprecision is their enemy, and it could damage or end their business. An audit means time not spent on their customers and money not spent on growing their enterprise. 

Slapdash or lost documentation will only prolong an audit with little chance of a positive result. Mention the financial and criminal penalties that might be incurred as a result of erroneous tax filings. Then remind them: the better their records, the better they'll understand their own business. That insight could lead to decisions that grow the business through their own acumen. Lenders like clean books, too.

Get them started by clearly delineating what they should be tracking. This checklist is a great start. Inspire them to keep expense journals, then collect that information into a general ledger. Some businesses may still want to rely on a spreadsheet. If they do, warn them to be careful to avoid copying formulas to the wrong cell or sheet, to double-check their entries aren't transposed digits, and record everything.

Trending

The trend now is for technology to make the processes straightforward and trouble-free. A financial document management platform can capture and organize any type of document in any format from any source. It can scan paper, grab a photo from a phone, and capture email receipts. Users can search, sort and find documents, types of charges, vendors, and even financial document line items. The data can be manipulated within the documents (for instance, separating personal line items from business expenses on the same receipt), shared with key people (like you) for collaboration, and can provide reports that can be used for understanding the business and undertaking better tax planning. This provides accuracy and reduces the burden on business owners and facilitated through secure unified mobile and desktop environments. Younger clients will particularly appreciate this recommendation as they expect that there should be "an app for that."

Just remind your clients to establish a process and employ it faithfully.

We'll know better next year how the expanded IRS workforce and enforcement directive plays out with smaller businesses. But if your clients are prepared for a tax audit because they've tightened up their record-keeping and used available technology, there's only potential upside. Any audit should be (relatively) trouble-free; their business will be in better shape; and the bill you present won't be onerous.