How to ace an audit

January 25, 2012

As a medical student, you didn't prepare for the boards the night before. Why do that when facing an IRS audit?

Key Points

Although the chances of a line-by-line Internal Revenue Service (IRS) audit are slim, the pain and suffering of an audit is immense. The IRS 2010 Data Book reports that roughly 70% of all small (corporations with $10 million in assets or less) corporate returns that the IRS audited or examined were changed.

The average recommended additional tax per return for a small corporation was about $30,000, and 62% of all partnership (including limited liability corporation) and S corporation returns under audit were changed. Data do not exist for the change of tax for partnership and S corporation returns, because these information returns are reported on the individual shareholder or stockholder returns. How many practices can sustain a $30,000 reduction to cash flow without making employment changes or accessing a line of credit? Proper record keeping, therefore, is not just essential. It's critical.

Cost is a key component to recordkeeping for every medical practice, and you will need to consider numerous cost-related factors when preparing for an audit. For example, what are the costs associated with properly recording, organizing, and sorting your records now? On the other hand, what are the costs associated with gathering, recording, and organizing documentation that is several years old for the purpose of an audit?

Today, many records are readily available online. The trouble with online records, however, is that an item is usually posted only for a limited time. A gathering mission for old records in preparation for an audit can take hours or days, time that could be better used serving current patients and developing your practice.

Recently, a new client of ours received a letter informing him he would be audited by the IRS. To be thrifty, the practice owner thought he could handle the accounting and tax preparation function and audit defense alone. After the first meeting with the auditor, however, the doctor engaged our firm. He had not kept proper records for several years.

We were assigned the task of reconstructing the information and attempting to reconcile that information with the audited return. It cost $7,000 in accounting fees to reconstruct just 1 year of financial information, roughly $1,000 in check fees, and several hundred dollars for monthly credit card statements.

In all, we estimated it cost the practice $10,000 to reconstruct and gather that 1 year's worth of transactions. In addition, the physician was forced to use countless hours of his personal time acquiring the necessary information and reports. Not only that, he had to spend additional hours with us recalling the transactions that were not originally documented. In short, his "thrift" wound up costing him time and money.

Keeping records up to date always is less costly than having to scramble to pull records together at the last minute with the auditor standing on your doorstep. The necessary records often are inaccessible, if not nonexistent, making it much more difficult to retrieve them several years after transactions occurred.

Unorganized and/or improperly stored records and the delayed recording of transactions may cost a practice additional taxes, penalties, and interest, as well as increased professional fees. Trying to prepare for an audit at the last minute can get expensive surprisingly quickly.