Q&As: How to Prepare for a Tax Audit

Q: Can I deduct the cost of my home office?

A: The rules on home office deductibility seem to change constantly. The U.S. Internal Revenue Service is very careful about the proper deduction of home office expenses. By deducting your home office, even legitimately, you increase your audit chances. To deduct a home office, the office must be used exclusively as the principal place for operating your business.

The U.S. Supreme Court has ruled that more than 50 percent of the total time spent operating your business must be spent in the home office. This is a problem for consultants who spend a significant amount of time at client locations, or for salespeople, who are typically on the road. Furthermore, by deducting the cost of a home office, you are likely increasing the chances that your tax return will be audited.

Q: How should I prepare for a tax audit?

A: The best time to prepare for a tax audit is now. It is much easier to keep good records today than to try to recreate them two or three years later. Remember, tax auditors don’t simply expect you to be able to find or eventually prove the deductibility of an expense. They expect you, during an audit, to instantly produce an invoice that substantiates the expense and proof that you actually paid the invoice, such as bank records.

Usually, a tax audit will specify the year being audited. Be sure to have all your records for the specified year organized and accessible prior to the audit. Try to determine, in advance, which items the auditor intends to question, and have ready answers.

Remember, the auditor’s questions will stem from information you supplied on your tax return. Are your office supply expenses extremely high? The auditor may want you to substantiate these expenses with invoices and/or cancelled checks.

I suggest that you have your outside accountant present during the audit. Ask him or her for advice relevant to your situation. If you are nervous, consider having the accountant be your representative and don’t attend the audit in person.

Q: Can I recover previous years’ taxes if I have a loss?

A: In the U.S., the IRS generally allows both corporations and individuals to use a current year loss to recover taxes that were paid during the previous two years. Then, any remaining excess may be used to apply against taxes for the following 20 years.

There are some issues and limits. For example, a corporation can only deduct capital (as opposed to operating) losses up to the extent it has capital gains. But it can carry them backward (three years) or forward (five years). Most states, however, do not permit individuals to adjust for business losses.

Q: Can I delay filing my tax return?

A: Any corporation, S corporation, partnership, or individual can get an automatic extension of time to file a tax return by simply filing the appropriate federal and/or state form in the U.S. Any tax due, however, must be included with the extension on the original date due. All taxes paid after the original date due are subject to interest charges. Inadequate payment with the extension request can also lead to additional penalties. Of course, the business must also continue paying its upcoming tax estimates on the current year’s income, too.

Q: What if my estimated tax payments appear to be too low at a later date?

A: If you find during the year that your income tax liability is going to be greater than the estimated taxes you have paid will cover, then you should revise any remaining payments to account for the increase. It is best to make any catch-up payments with the next payment due.

About Bob Adams

Bob Adams is a Harvard MBA serial entrepreneur. He has started over a dozen businesses including one that he launched with $1500 and sold for $40 million. He has written 17 books and created 52 online courses for entrepreneurs. Bob also founded BusinessTown, the go-to learning platform for starting and running a business.