One of the biggest fears of most business owners is being informed by the Internal Revenue Service that their income tax returns will be audited. These fears were compounded by the recent Congressional hearings detailing taxpayer abuses by the IRS.

From confidential information I’ve gathered, it appears that the IRS is stepping up its audits of business returns, particularly “S” corporations like Blau Plumbing, Inc. “S” corporations are more of a target than in the past simply because they had not been targeted as often as “C” corporations.

Owners need not fear an IRS audit if they are properly prepared for one, if the income and deductions stated on returns are beyond reproach, and they can be supported by documentation. Additionally, it is important to have competent professional representation.

Notice Of The Audit: Here is the notice, word for word, that my company received from the IRS District Director, dated April 29, 1997.

“Your Form 1120S, U.S. Corporation Income Tax Return for the year 1995, has been selected on a random basis for examination. An appointment for you has been arranged as shown above.” (Scheduled for May 28/29, 1997, at my office.)

“You may have an attorney, a certified public accountant, an individual enrolled to practice before the Internal Revenue Service, or a qualified unenrolled individual represent you or accompany you. However, your representative must have written authorization to represent you. Form 2848, Authorization and Declaration, may be used for this purpose. If your representative does not have copies of this form, they may be obtained from one of our offices. Also, any other individual, even though not qualified to represent you, may serve as a witness to assist in establishing the facts in your case.

“To help make the examination as brief as possible, please have available the records listed on the enclosed Form 4564, Information Document Request, if they apply to you.

“If this appointment is not convenient, I will reschedule it if you will call or write me. If I do not hear from you within 10 days, I will consider the appointment confirmed. Thank you for your cooperation.”

Following is the list of the documents requested.

1. Corporate minute book.

2. General ledger and chart of accounts.

3. Cash receipts and disbursement journal.

4. Bank statements and canceled checks.

5. Payroll records and 940s and 941s. (I thought they were lottery ticket stubs, but found out differently!)

6. Trial balance for 1995.

7. Notes between shareholders and the corporation and vice versa.

8. Pension and profit sharing forms filed. (We got them — big time.)

9. Copy of prior and latest returns of the corporation.

10. Copies of prior audit reports. (We had some.)

11. Detailed depreciation records.

12. Returns of shareholders owning 50 percent or more stock. (That’s me.)

13. Records of loans, mortgages, savings accounts and stock and bond investments. (Nosy people.)

14. Copies of accountant’s work papers.

15. Copies of invoices for all expenses.

In addition to the above, we received two documents titled “Your Rights as a Taxpayer,” plus “Notice 609 — Privacy Act Notice.” Both are available from the IRS upon request. I recommend that every contractor have both notices in your files in anticipation of a future audit.

Preparing For The Audit: After reviewing this communication, I delegated the project to my numbers-crunching son, Bob, because I didn’t need the B.S. at my age. Besides, I’ve experienced three other IRS audits and the same number of state audits during my 37 years in business. I figured it’s about time the young ones learn what it’s all about. I never got to meet the agent face to face, even though the notice was addressed to me.

Bob immediately contacted our tax attorney/CPA (a former Wisconsin tax auditor) to advise him of the audit notice. Power of attorney was granted to him promptly. All necessary records from 1995 were gathered from our storage facilities and properly placed in one of our offices, which was totally dedicated to the audit.

While all of this was going on, the big questions in my mind were, “Why tax year 1995? What the hell were they looking for? What triggered the audit?” I was determined to find out.

I learned a long time ago that first impressions are lasting impressions, and that applies to the IRS as well as anyone else. If the business owner and his legal representative appear to be well organized and prepared, it sets the tone for the duration of the audit. If the agent sees disorganization, s/he will likely dig deeper into a variety of areas, knowing that there may not be adequate substantiation.

Double Whammy: “D-day” arrived and not one, but two auditors showed up. Both my son and the attorney/CPA were present to welcome both of them. To the surprise of the feds, the Blau team announced that we would be tape recording the initial conversation — laying down the ground rules pertaining to future requests for additional records, questions, etc.

One of the most important ground rules established was that any question the IRS might have would be answered by legal counsel only. The agents would have to submit the questions on Form 4564 no later than 3:00 p.m. daily. The information would then be faxed to legal counsel, who in turn would confer with Bob and then deal with the feds. This format worked great.

If you followed the news about the Congressional IRS hearings in September, you heard IRS insiders testify that the agency tends to “pick on” unsophisticated business owners. They had to realize they were not dealing with slugs at Blau Plumbing.

The Audit Process: In addition to scrutinizing items 1–15, our friendly auditor requested various other information. Among those requests, with our legal counsel’s responses were the following:

• “List duties and responsibilities of Frank J. Blau, Jr. and time devoted to S Corporation.” Legal counsel responded, “Why do you want to know?” Inquiry was dropped.
• “List duties and responsibilities of Edward Blau (my brother and former business partner) and time devoted to S Corporation.” Legal counsel response: “Why do you want to know?” Inquiry dropped.
• “Copy of Edward M. Blau’s personal return for 1995.” Provided.
• “What happens with scrap metals materials from various jobs?” Legal counsel response: Scrap dealer removes it from Blau Plumbing facilities; Blau receives no compensation from dealer.
• “How is Frank J. Blau, Jr. Associates, which operates as a ‘C’ business, connected to the S Corporation?” Legal counsel response: It’s not.
• The auditor also requested sale and purchase journals for 1995 and 1996, invoices for highlighted items on legal and professional fees, a LIFO reserve account schedule and invoices for other selected purchases. All were provided.

There were additional questions presented by our friendly auditor, all of which our legal beagle politely responded to. All in all, the audit was conducted with a high level of professionalism on both sides, with my dear son Bob emerging as a superstar. Bob, myself and legal counsel all feel that the audit went smoothly, and none of us felt abused by the IRS.

My only annoyance with the IRS is that while one of the auditors mentioned to Bob that everything looked “A-OK,” as of this writing on Sept. 30 we still have not been notified in writing that the audit is concluded and no further taxes are due for the tax year in question. More than four months have passed since the audit, which should be plenty of time to process the paperwork and make decisions.

Conclusion: The time for preparing proper documentation should be long before a PHC contractor gets notified of an IRS audit. Accurate and organized recordkeeping is something that needs to be done in the regular course of business. Good recordkeeping not only provides substantiation for an IRS audit, but helps a business owner to understand how the business is doing on an ongoing basis. Unfortunately, this doesn’t seem to be the norm with most PHC businesses.

Remember, the burden of proof rests with the owner to defend any challenge from the IRS. Without good records, the audit can be more difficult and time consuming than necessary.