The IRS vs. Inventors

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All inventors, particularly those who report deductible losses year after year, need to be concerned about IRS audits. In an audit, the IRS examines you, your business, your tax returns and the records used to create the returns. If an IRS auditor determines you didn’t pay enough tax, you’ll have to pay the amount due plus interest and penalties. 

As a general rule, the changes of being audited in any given year are not very high. However, the IRS still needs to be taken seriously. The fact that overall audit rates are low doesn’t guarantee you won’t get audited. Indeed, if, like many independent inventors, you incur losses each year, you probably have a higher chance of being audited than business owners who report profits. This doesn’t mean you shouldn’t take all the deductions to which you’re legally entitled. But it does mean that you must understand the rules and be able to back up your deductions with proper records.

Types of IRS Audits

There are three types of audits:

  • correspondence audits
  • office audits, and 
  • field audits

Correspondence audits: Correspondence audits are handled by mail or phone. These are the simplest and shortest type of IRS audit, ordinarily involving a single issue. The IRS sends you written questions about a perceived problem, and may request additional information and/or documentation. If you don’t provide satisfactory answers or information, you’ll be assessed additional taxes. Correspondence audits are often used, for example, to question a patent owner about unreported income -- income the IRS knows the taxpayer received because an IRS Form1099 form listing the payment has been filed by a patent licensee. Correspondence audits are the most common type of IRS audits.

Office audits: Office audits take place faceto-face with an IRS auditor at one of the 33 IRS district offices. These are more complex than correspondence audits, often involving more than one issue or more than one tax year. If you make less than $100,000 per year, this is the type of face-to-face audit you’ll likely be subjected to.

Field audits: The field audit is the most comprehensive IRS audit, conducted by an experienced revenue officer. A field audit examines your finances, your business, your tax returns, and the records used to create the returns. As the name implies, a field audit is normally conducted at the taxpayer’s place of business -- this is so the auditor can learn as much about your business as possible. Field audits are ordinarily reserved for taxpayers who earn a lot of money. It’s not likely you’ll be subjected to one unless your inventing business earns more than $100,000 per year.

What the Auditor Does

IRS auditors look primarily at two issues: whether you’ve underreported your income and whether you’ve claimed tax deductions to which you’re not entitled -- for example, claimed that nondeductible personal expenses were deductible business expenses. Using a separate bank account for your business expenses will help convince the auditor that you’re not mixing your personal bills with your business expenses.

The auditor will want to see the business records you used to prepare your tax returns, including your books, check registers, canceled checks and receipts. The auditor will also ask to see your records supporting your business tax deductions.

IRS auditors can also obtain your bank records, either from you or your bank, and check them to see if your deposits match the income you reported on your tax return. If the total of all your deposits is larger than your reported income, the auditor will assume you failed to report all your income, unless you can show that the deposits you didn’t include in your tax return weren’t income -- for example, that they were loans, inheritances, or transfers from other accounts. This is why you need to keep good records of your income.

Handling Audits

You have the legal right to take anyone along with you to help during an audit -- a bookkeeper, tax pro or even an attorney. If you’ve hired a tax pro to prepare your returns, it can be helpful for him or her to attend the audit to help explain your business receipts and records and to explain how the returns were prepared. Some tax pros include free audit services as part of a tax preparation package.

However, if you prepared your tax returns yourself, you can probably deal with an office audit yourself. It could cost more to hire a tax pro to represent you in an office audit than the IRS is likely to bill you. If you’re worried that some serious irregularity will come to light -- for example, you’ve taken a huge deduction and can’t produce a receipt or canceled check to verify it -- consult with a tax pro before the audit.

No matter who prepared your tax returns, it usually makes sense to have a tax pro represent you in a field audit, since these can result in very substantial assessments.