When the IRS Calls

What to Expect, What to Do

By Kathy Gruver

It was a Friday and my husband and I had planned a nice dinner and movie at home. I stopped at the mailbox after a long day of massages. As I flipped through the mail, I saw it. My stomach dropped and a wave of anxiety came over me. I looked again and there was another identical letter for my husband. I opened the envelopes right there in the street and a wave of panic washed over me. My husband and I were being audited.

The next three months of our lives included stacks of paper, calls to our accountant, lots of math, paper clips, highlighters, frustration, binder clips, anxious thoughts in the middle of the night, and teeny receipts you couldn’t read. I survived the process and now want to share my experience—not just the technical things I did to prepare, but also my feelings and how I handled it. If you ever find yourself in this position, my experience might offer you a little better idea of what to expect, what to do, and how it may feel.

The Unknown

One of the scariest things for me in this process was the unknown quality of an Internal Revenue Service (IRS) audit. Even if you know you didn’t do anything wrong, you can’t help but feel nervous and uneasy when that letter arrives. You don’t know exactly which receipt or transaction they might want to see. I had about 15 clients who had gone through an audit, but everyone had a completely different experience, so their individual cases didn’t offer me any real insight. It was good to see they lived through it, though, and still had enough money left to come to me as a client. Then again, I had one gentleman who had been audited eight years in a row. The stories scared me.

The first choice my husband and I made was to have an “enrolled agent” represent us. Our agent, an accountant at the firm that does our taxes, had been through intense IRS training and testing. When you go into an audit with a representative like this, you’re often perceived differently. Now, not everyone wants to go that route and it is pricey. Most charge $100 per hour for their preparation work and representation time. I wouldn’t have had it any other way, though. He guided us through the process, communicated with the IRS auditor, set up the appointment, showed us how to arrange our records for maximum result, and sat with me on the big day and fielded most of the questions. It was a comfort to have an experienced person help us through this process. If you can afford it, I highly recommend this kind of representation.

The Prep Begins

We dug out the 2008 taxes—the year they wanted to examine. The IRS asked for all Schedule C activity, bank accounts, mileage, and travel logs. I tend to be pretty organized already and figured getting this information together was going to be easy. Clients told me they spent between 40 and 60 hours preparing for their audits; I thought they were nuts. I mean how long could it take? I had no idea. I compared the spreadsheet I sent to our accountant with the Schedule C they had filed. Some of the categories were different and it was a time-consuming challenge to match up their numbers with my numbers. My advice: find out what categories your accountant uses in preparing your taxes and use similar accounts. My accountant combined some of my numbers into one category for space purposes and it was a huge challenge to get everything matched up.

Our representative, Ernie, wanted us to enter every receipt into a spreadsheet. This was also time-consuming because everything had to be put in the right category and entered in date order with an added explanation. The receipts then needed to be put in matching order. I now realize that doing this when you prepare your taxes is probably a good way to go; I discovered I had actually cheated myself out of a few receipts.

I then examined the bank records. I added up all my deposits and realized the numbers didn’t match. My deposits didn’t match the income I claimed. I was short, and not in my favor. How could this have happened? I pride myself on being fastidious with my records. I went back through my appointment book and spreadsheets. Clearly my knowledge of the spreadsheet software wasn’t as good as I thought it was, and some of the spreadsheet wasn’t included in the total. I messed up my formula and panicked. Not only was I going to owe tax on that money, but also I was afraid they’d think I did it on purpose. I woke up in the middle of the night in panic about this issue several times. I felt terrible and embarrassed. I didn’t normally make mistakes like this.

Also at issue was the fact that I only had one bank account. As a result, I had to prove all my non-income deposits were truly not income. For example, I did an event where I was reimbursed for expenses. That wasn’t income, but I had to prove it. I had to write to the organization and get a letter saying that it was a reimbursement. Same thing with the repayment of a loan I had given to a family member, and birthday money from my aunt and uncle. You get the idea. It became an overwhelming task. If you don’t have a separate business account, I recommend getting one. At the very least, make sure you track all of your deposits and note what is not income.

As I prepared for the audit, I figured I could just contact my bank and look at all my deposits. They keep all that stuff, right? My husband did this with his bank and it cost him $25. I contacted my bank; it was $5 per deposit. I do deposits every week, so that was going to be pricey. But then they clarified: not per deposit, but per deposited check. In my case that meant 15–20 checks per week. For me to look at all my deposits for the year would have cost around $5,000. Needless to say, I was furious. In the end, I spent $550 to look at 12 days of deposits. I picked ones that seemed unusually high or came at strange times of year. I only found one deposit that wasn’t income that I didn’t already know about. It was for $35. Keep close track of your deposits and you might want to check with your bank so you know in advance what their policies are regarding your records. Better yet, go the route of separate bank accounts so you know 100 percent of your deposits are income; then limit the transfers between accounts.

The more I did this research and put my spreadsheets together, the more categories of receipts I found that weren’t calculated quite right. I had originally reported $450 in postage, but actually found receipts for $515. Some were higher, some were lower. It’s amazing what you discover when you look at things carefully. But I was frustrated with myself; so many little things were slightly off. I contacted Ernie and explained that I was finding a few dollars here and there that were wrong and between that and the income discrepancy, couldn’t we just do an amended return for the audit. It seemed to me the best thing was to be up front and say, “Look, I screwed up. I know I owe. Here’s what we have.” He totally agreed, so we started to prepare the new documents.

The day of the audit was drawing near and I feared I wouldn’t have enough time to get things done. Gathering letters from people, organizing receipts, making sure my mileage log was in order—the details were nerve-racking and time-consuming. In the meantime, I was still running my business, doing massage, releasing a book, and preparing for a trip overseas. The nightly panic started to subside when we decided to do the amended return. I found that once I knew the facts of what was happening and felt more in control of the process, I started settling down. I made a mistake. People make mistakes and I knew I owed. It was only money, and money that I legitimately should have paid. There are no debtor’s prisons, they weren’t going to carry me off to the square to shackle me and have people spit on me.

One thing I learned from this process was to revise my view on money. There are so many more important things. I realized that the material things could be taken away at any moment. What couldn’t be taken was the love of my family, the help that I am giving to my clients, and their smiles, thank yous, and warm hugs. No one could take away laughing with my husband or enjoying my new kitten. Those things are so much more important than money. I learned to keep life in perspective.

Three Days to Go

A few days before the audit, I turned in my mileage log to Ernie—my last item. I kept one, but it was difficult to read and I wanted to make sure it was clear and the math was correct. If you deduct business mileage, you are required to maintain a log. Make sure you do yours on a daily or per-trip basis. Trying to recreate that at the end of the year is a time-consuming challenge. You must also note the beginning and ending odometer reading for the year. The morning I confirmed my mileage with Ernie and finished the log, I felt as if an enormous weight had been lifted from me. I estimated that I spent about 50–60 hours prepping for this event. I can’t imagine how long it would take someone who wasn’t organized. Throughout the year, I had divided up my receipts into categories, so that had saved some time. Ernie recommended entering them directly into a spreadsheet on a daily basis. It would have been helpful for me then, but it’s definitely how I operate now. Today, I keep records as if I’m going to be audited again tomorrow. I hope it never happens, but I’ll be prepared.

I thought I was done, but more things kept coming up. I needed to take photos of my home office. I had one last email to answer. I couldn’t find that one cancelled check for the post office box. There was so much paper lying around now I couldn’t remember if I had seen it, thrown it away, filed it, filed it incorrectly, written it down, or if the cat shredded it. It was confusing, but I’m glad I did it in stages, little by little. This is not the time to cram everything in the last few days. I definitely underestimated how long this process would take. Even with three months to prepare, I found myself scrambling a bit at the end.

The Dreaded Day

The day of the audit, I saw one nursing-home client in the morning and then met Ernie at my house to review before the 1:30 meeting. His goal was to prep me to answer questions, as well as review the basic procedures and time line of the IRS meeting.

Ernie said the first thing the IRS would do is ask general questions and get basic background on us and our businesses, proving we are legitimate. My husband is a writer and had a loss that year so we figured we’d have to defend that he was an actual for-profit business and not a hobby. The IRS has specific rules about how many years you can claim a loss before it raises red flags (consult your accountant for more details).

The auditor would want to look at bank statements, followed by receipts—typically starting with large ones or ones that are commonly disallowed, like meals, gifts, and travel. Remember to only count business meals at 50 percent and that clothing, other than uniforms, is not an allowable expense. Check with your accountant for specific details on what is an acceptable deduction.

Here’s a very important note—do not make things up you can’t substantiate. If you don’t have a valid receipt, don’t make up expenses. This is why it’s important to make sure you keep all business receipts. Or, if it’s a small amount that you wouldn’t get a receipt for like parking meter money, make sure you write down the details and the dates in a journal or notebook. Keep really good track of your income and don’t try to hide money. Dishonesty will inevitably come back to haunt you. There are allowable expenses in place to reduce our tax burden. Take them; it’s your right as a business owner. But only take what is legal and allowable and make sure you have records to back everything up.

When I told other massage therapists about my audit, they shuddered in fear and told me they have horrible records, don’t keep any receipts, and have no idea of their income. Bad idea—don’t be one of those people. And don’t be one of those people who thinks it couldn’t happen to you. It can.

After spending an hour reviewing procedure with Ernie, he told me our return was so complicated our audit might be a two-day process. I wasn’t happy to hear that. To think I might miss another day of work and have this drag on longer was frustrating and depressing. But, it was time to get in the car; we had to go.

At the IRS

The auditor turned out to be a recent university graduate who was the nicest guy ever. I relaxed a bit when I saw him; I had expected a grey-haired, cranky man. We went into a small office with our five large stacks of documents and the first thing he asked was whether we found any errors, discrepancies, or anything else they need to know about. We responded with our corrected forms, showing him the income and expenses error. He didn’t ask why it happened. He didn’t make me feel corrupt, guilty, or stupid. He just said, “Great, thanks for redoing that form and for being up front about the error. That makes everything so much easier.” I was relieved.

He then asked general questions like:

• Do you get money from any sources like inheritance, trusts, or moneymaking hobbies?

• Do you have large stashes of cash at home?

• What are your rent/car/credit card expenses?

The goal of the auditor is to determine that all of your numbers make sense. If you claim $30,000 in income and have $45,000 in everyday expenses, obviously something is wrong. This is why you need to be up front with income and expenses. The government is not stupid and will notice if you are living beyond what you claim your means are.

Then he asked business-specific questions:

• What is your background?

• How long have you been doing massage here?

• What kind of training is necessary?

• How much do you charge?

• How many hours do you work a week?

• Do you do any trades? (I don’t, but did you know you’re supposed to claim that as income? Ask your accountant.)

Next he looked at my mileage log and was impressed I actually keep a formal mileage logbook. He glanced at my banking, looked at two categories of receipts, and moved on to my husband. I was done in 40 minutes. With the organization of our records, the amount of evidence we presented, and the admitted error we reported (in their favor), the process was smooth and quick.

The auditor took another 30 minutes to reconcile the new claim and figure the amount I owed. I wrote him a check and we were done. I almost wanted him to look at everything since we spent so much time gathering it. Had we not prepped the way we did, he surely would have looked more closely at every receipt. He told us that one couple came in with just a garbage bag full of receipts; it took days for their audit. The IRS assumes that if the taxpayer doesn’t know the details of the finances, why should the IRS trust the taxpayer’s work? My auditor trusted our work and I was thrilled. We did have to pay interest on the money owed, but it was a small price to pay and I did owe the money. He opted not to charge us a penalty (which he could have) and to not look at previous years (which he also could have). I was so relieved.

The Future

Ernie fully believes that my husband and I will be audited again in the next five years. I hope not, but if we are, here’s what will be different: I’ll check my income that I log against my deposits to make sure I don’t miss anything. I’ll have my receipts already entered in a spreadsheet and will only have one credit card for business. And though I still don’t have a separate business account, I’m taking advantage of the ATM that prints out check pictures on the receipt for all the checks I deposit. If we are audited again, I’ll know that it’s not malicious and that they’re not out to get us.

I hope you never have to go through an audit, but if you find yourself at the mailbox holding that envelope, I hope my experience can help you get through it. Perhaps it can give you some ideas to be more organized yourself, whether or not that letter ever arrives. 

 Kathy Gruver is a massage therapist, naturopath, and author of The Alternative Medicine Cabinet: Hundreds of Ways to Take Charge of Your Health Naturally (Infinity Publishing, 2010). For more information, visit www.thealternativemedicinecabinet.com.