Receipts are among the most important documents in bookkeeping. Bureaucratic processes surrounding holding onto different kinds of receipts, invoices, and documents can seem tedious or even unnecessary. But doing so can pay off – literally. In this guide, we explain why and how to order your documents, the different types of receipts, and the basics of bookkeeping.
The Audit: What you need to know about external audits
The Internal Revenue Service (IRS), state and local tax authorities earn billions of dollars a year through external audits of company financial records. As a result, it is not surprising that auditors take their jobs very seriously when it comes to inspecting questionable financial records. In principle, nobody is exempt from being audited, whether they are a large company or a small freelancer. Yet it is very unlikely for them to investigate an entity that generates low revenues. Though it is possible, if there are anomalies, that a private household can be audited by the tax authorities if they get the impression that a taxpayer has not submitted accurate accounting and tax returns.
If a tax office audit does occur, there’s no need to panic. Simply use the time after you are notified of the investigation to prepare as thoroughly as possible, by finding out as much as you can about the general procedure and basic functions of an external audit. Once you have done your research, you can create an optimal starting position for your upcoming audit investigation. This won’t just calm your own nerves but will considerably simplify the external auditor’s work and speed up the process.
- What is an external audit?
- Why and when will an audit by the tax authorities take place?
- An overview of the audit procedure: process, duration, etc.
- What do tax auditors pay attention to?
- How to prepare as best you can for an audit
- Avoiding an audit – the best tips
What is an external audit?
Tax authorities are permitted to investigate the accounts of tax-paying individuals and companies, even if they have submitted tax returns and annual accounts. This investigation consists of registered visits to your company’s office or home. Traditionally, this type of verification visit is referred to as an external audit. However, since tax authorities generally tend to pursue investigations against businesses more frequently than against individuals, the term audit is much more common, even if this term might give a false impression that only companies and businesses can be audited.
An external audit or operational inspection may also take place entirely through electronic form. In this case, the auditor from the relevant tax authorities only requires access to the account’s digital data.
Whether it’s the federal, state or local tax authorities who are investigating you, the tax authorities are always required to provide ample notification to the persons/companies concerned either in writing or by telephone (often both) about the planned inspection and the date the investigation is due to commence. They will inform you what types of tax documents, tax allowances or premiums will be reviewed or for how long the audit period (typically three years) is scheduled. The tax office can also inform you which tax auditor will be responsible for the audit. However, this is not a mandatory disclosure.
The external audit (also known as an external audit in the field of tax law) is an in-depth inspection and review of tax-relevant matters. The tax authorities are responsible for initiating and carrying out an audit and are also responsible for assessing the income taxes of the persons or companies under investigation. The aim of an external audit is to ensure taxation uniformity.
Why and when will an audit by the tax authorities take place?
All American citizens and individuals who work and earn money in the USA are required to pay taxes. In order to comply with this obligation, all tax-relevant matters are subject to the control of tax authorities at the federal level (IRS), as well as state and local level, depending on where you live. The necessary materials for this control and investigation are handed over to the relevant tax authorities in the form of an annual (or quarterly) tax return. These can be complicated to file leading to avoidable mistakes, and an unclear tax status for many. The external audit can help clarify the tax status and liabilities of a taxpayer.
As previously mentioned, anyone can be investigated, whether it’s a private company, individual trader or freelancer. However, most investigations are audits on large companies, and the rule of thumb is that the larger a company, the more likely they are to be audited. In addition, there are several factors that increase the likelihood and frequency of an audit:
- Tax return seems implausible
- Tax return is filed too late
- Taxes are paid late on a regular basis
- Profits fluctuate wildly from previous year
- Turnover or profits are unusual for the size of the company/industry
- Labor costs are disproportionately low
- A previous audit resulted in significant tax repayments
An overview of the audit procedure: process, duration, etc.
Audits can be divided into roughly three stages:
Investigation registration and examination order
First and foremost, the tax office will register their audit. They will inform the party being investigated of the upcoming investigation and where it will take place. In general, audits take place either on the premises of the party concerned, or their tax adviser. However, if you cannot provide the auditor with a place of employment, for example, then the audit may take place at the tax office. Parties under investigation will receive an appointment for the start of the investigation, however, it can be postponed through consultation with the tax office if your accountant or tax adviser is on vacation at that time, or if you are busy processing a large order, for example.
At least two weeks before the audit begins, the tax authorities will send you the investigation order document, which defines, among other things, the relevant period being covered by the audit. In some cases, however, the examination period may be more than three years – for example, in case the party being investigated is under suspicion of a criminal offense or administrative offense. The order also tells you which taxes the auditor wants to consult during their visit, so that you can gather and arrange relevant documents in advance.
Executing the audit investigation
The second phase is the actual execution of the audit. This takes place at the agreed-upon location during normal business hours. You are obliged to grant the auditor access to your premises or property. Typically, the auditor visits your company first before the actual audit begins, regardless of whether it takes place at your home/office, your tax adviser’s premises or at the tax office.
You must provide the auditor with one or more contact person(s) for the entire period of the audit. The auditor can contact them if they have any questions or want to consult certain books, business documents or other financial documents from the accounting department. The duration of this operational review can vary wildly depending on the size of the company and the scope of the documents required: from one to two working days up to several weeks, anything is possible.
It is imperative that you comply with requests for participation as soon as possible. If the auditor finds evidence of a criminal offense during their audit, they will immediately report it to the relevant authorities.
The final phase of the audit is the final meeting. The head of the tax authorities often participates in this interview, alongside the auditor. In order to prepare for this meeting as thoroughly as possible, you should ask the auditor for a written notification in which they list their findings, including relevant references as well as the number of tax repayments. Together with your tax adviser, who is also permitted to attend this meeting, you can review the agenda for the meeting in advance and work out arguments against any potentially unfavorable findings.
The final meeting does not have to take place if the investigation does not result in any significant findings, or if the auditor or tax authorities fail to schedule the meeting.
A tabular overview of the most important data during an audit:
|Who performs an audit?||An auditor on behalf of the investigating tax authority.|
|When does an audit start?||Two weeks after receiving the investigation notice.|
|Where does the audit take place?||At the taxpayer’s premises (office or home), at the tax adviser’s premises or, in justified cases, at the tax office.|
|How long does an audit take?||Between one and two days (for individuals or small businesses) or up to a few weeks (for large enterprises)|
|What is the period for an audit?||Generally, three continuous tax periods|
|What is the frequency with which an audit can be expected?||The frequency depends on the size of the company and the sales/profit level, among other things|
|What taxes can be audited?||Corporation tax, income tax, sales tax, input tax, etc.|
|What obligations do taxpayers under audit have?||Obligation to cooperate: grant access to requested documents, answer questions about unclear facts or records, etc.|
The proper transfer of payroll tax for employees, temporary employees and contractors is subject to a specific external payroll tax audit.
What do tax auditors pay attention to?
One of the most important basic rules that you should always observe when it comes to an external audit is that your accounting must always be kept legally up to date. If there have been legislative changes within the period being audited, your auditor will check whether you have immediately implemented these changes in your accounting or tax return. Additionally, there are several other areas that auditors pay attention to.
Contracts with family members
Any type of loan, company, rental or particularly employment contract being awarded to a spouse, child or other family member are often the focus of auditing cases by the tax authorities. The main issue in this instance is whether the terms of the contract are appropriate and in order. For example, the tax authorities will check whether salaries, profit shares, interest, voting rights or rental rates are within the normal range, or whether there is a glaring discrepancy between other employee or business partner contracts. In addition, the auditor will ensure that family members are not being employed for bogus work by checking whether their position exists and whether a salary has been demonstrably paid (i.e. transfer documents).
Costs incurred on business trips with private vehicles or company cars which are then deducted as tax write-offs are also closely monitored. If the vehicle or driver possesses a driver’s logbook, it will likely be reviewed during the audit. If the auditor finds inconsistencies, negligence or errors, the logbook will not be accepted as valid. The auditor will also check whether company cars are used solely for business purposes, or also for private trips. In this instance, additional tax penalties may be incurred if infringements are found.
If you have incurred losses during several consecutive financial years, it will cause suspicion for the tax office. It will quickly become obvious that you have no intention of making a profit, but that the losses are due to deliberate personal reasons or inclination. If you do not have a convincing business plan ready to show the auditor to indicate that you intend to become profitable soon, the tax office could impose financial penalties.
Deviations between quotations and invoices
Tax auditors also sometimes pay close attention to inconsistencies between quotes and subsequent invoices. For example, if invoice amounts are significantly lower than the sums declared in the quote, the auditor will quickly become suspicious that undeclared work is being done. You should be able to explain the reason for any significant discrepancies – preferably with documentation (post, email, etc.) with the customer in question. If the auditor’s suspicions are confirmed, there could be severe tax and even criminal penalties on the line.
Those who are required to keep accounts should also keep a cash register where all cash receipts and expenses are recorded daily. Irregularities in the cash register roll are often the reason for complaints from the tax authorities.
If you are a business owner, such as a farmer, and you take less money from the farm as income than is credibly required for your livelihood (e.g. housing expenses, food, clothing, etc.) and you have no other sources of income, the tax office will check carefully whether or not you are engaged in undeclared work.
How to prepare as best you can for an audit
The most important aspect of preparing for an upcoming audit is to get all your accounts in order. Make sure you have all the necessary documentation ready to be checked, as well as complete presentation of your business processes and any documents used for calculating sales, expenses etc. Sort through your invoices, tax and miscellaneous business documents in advance to allow the auditor to work as quickly and easily as possible. If you find that certain documents are missing, use the time before the investigation formally begins to fill in the gaps.
Any major items like equipment, carpets or artwork that you have purchased and deducted as a tax write-off for your company during the period under audit should be displayed in your office when the auditor is on-site. Many tax auditors will be keeping an eye out for these details.
Try to anticipate the needs of the auditor before they arrive. However, also bear in mind that as the main individual responsible for a company, you are bound by your obligation to provide information and cooperate. There is also a possibility that the auditor may seek to interview employees who have not been designated as respondents. In order to avoid potential misunderstandings during these interactions, you should also inform all other employees about the upcoming audit.
Of course, you must also ensure that your tax adviser is involved in all preparation for the audit. Clarify what tasks you want them to handle in advance during the audit and set a fee ceiling to avoid any nasty surprises when it is over.
Avoiding an audit – the best tips
As mentioned at the beginning, anyone can be subject to an audit. For large companies, audits are commonplace and often just a matter of time. However, you can increase your chances of avoiding an audit for as long as possible, as well as lay down the groundwork for a quick and painless investigation once it eventually happens. To do this, take the following things into account when bookkeeping:
- Always mail receipts immediately and store your copy right away afterward
- Ensure care when bookkeeping and make sure your practices are legally up to date
- Always answer questions from the tax office accurately and on time
- Inform the tax office in good time if you will be unable to meet a deadline, and politely ask for an extension
- Hire a tax adviser to prepare your annual financial statements or tax returns, or at least have them double-check yours before submitting
- Always pay your taxes on time