This is the first installment of a three part blog focused on how business owners and managers can successfully prepare for and manage a tax audit.

A tax audit is a confusing and intimidating event for most businesses and their owners, and almost always results in the business paying additional taxes, penalties and interest. As I help clients respond to tax audits, I find that people are often shocked at the outcome of the audit and devastated by the high cost to resolve it. I frequently hear comments like, “How can I owe so much money in taxes? I don’t make that much!” or “How can the IRS require me to pay that much? Do they really want to put me out of business?” or “My accountant takes care of filing my taxes, and has shown the auditor our records. It isn’t fair that the auditor won’t accept what he says!” Difficult financial times magnify these problems for businesses and their owners. When the economy slows down, businesses have lower profits and fewer resources to defend themselves. But declining profits mean declining tax revenues. Because government services must continue, government enforcement activities often increase in hard financial times.

A business needs several basic resources in order to successfully prepare for and respond to a tax audit. As with most business issues, advance planning can save tens of thousands of dollars in an audit situation and avoid costly, unnecessary litigation.

There are three areas on which businesses owners and managers need to focus to help avoid or be prepared for tax audits. First, business owners and managers need to understand the financial details of the business and manage the business profitably. Second owners and managers must actively participate in decisions concerning how financial results are reported to government agencies. Third, in today’s complex regulatory environment, every business needs the help of competent professionals who understand the business and who can effectively defend the justification for reporting positions.

This blog focuses on the first area: Owners and managers must understand the finances of the business.

Business owners often indicate that they cannot understand how a tax auditor can conclude they owe so much money when they see themselves as earning only a modest living. Often, such comments are evidence that the business owner may not understand the finances of his or her business. For example, a very common, difficult to solve problem is a business that spends more than it makes. The business may have significant gross revenues, many employees, and even lots of sales or work, but is liable for hundreds of thousands of dollars in payroll tax debt. Such a business typically has used available cash to pay employees, but can’t pay vendors on time and hasn’t reserved anything for payroll taxes or made tax deposits. The business owner may protest that there just isn’t enough money to pay employees and the taxes too.Such a business typically spends more than it makes and it is likely to fail without corrective action. Once under audit, the Internal Revenue Service or other taxing authorities may attempt the business to stop operating if the business cannot make current tax payments. All too often the cumulative impact of past and current tax liabilities and other debts make it impossible to timely pay payroll, taxes and vendor accounts, and the business finds itself closed or in bankruptcy. If payroll taxes are at issue, neither the business entity structure nor a bankruptcy filing will shield a business owner from personal liability to the government for taxes that were withheld from employees, but not paid to the IRS.

To be financially successful, businesses and their owners must live within their means. Owners and managers need to collect and organize revenue and expense data, and be able to measure and understand financial results. Many businesses struggle simply because they don’t have a functional accounting system. Whether the system is manual or electronic, it must provide regular and accurate information. Owners and managers should also use that information to make good management decisions. Bills need to be paid on time, and reserves established to pay upcoming liabilities, including taxes. At the outset, owners and managers should review all tax liabilities applicable to their businesses and understand how they are measured, reported and paid. These liabilities need to be reviewed periodically to ensure the business remains compliant. That list should always include federal and state income tax, payroll taxes, workers compensation charges, and state and local sales and use taxes.

How does proper financial management impact a tax audit? When business owners and managers understand the finances of their businesses, they are better prepared to understand and respond to an auditor’s assertions. They will recognize whether alleged deficiencies exist in the context of their businesses.They will know where to look for solutions and will likely have the documentation necessary to respond to an auditor’s questions. This knowledge empowers owners and managers to be able to identify whether an allegation can be answered with simple documentation, or whether there will be a debate concerning a technical point of law. It also enables owners and managers to work with their professional advisors in an efficient and effective manner.Finally, they will be able to make financial and operational adjustments to ensure that the business remains financially viable while resolving outstanding tax liabilities.

My next blog will focus on the responsibility business owners and managers accept when they sign a tax return, and what the government will expect of them in an audit.