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5 Tips for CPAs to Minimize Audit Risk for Their Clients

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If you are a CPA, here are 5 things to help your client reduce the risk of an EDD, IRS, or SBA audit:

If you are a CPA, here are 5 things to help your client reduce the risk of an EDD, IRS, or SBA audit:

1: Confirm that your client’s 1099-K (provided by a merchant processor) does not report gross proceeds from credit card sales that are higher than the amount you are reporting as “gross receipts” on a business income tax return. 

If there is a difference, you may consider adding a statement to explain a legitimate difference. For instance, chargebacks and returns are not subtracted from the amount of “gross proceeds” on the 1099-K form.

2: If you have a client who has more 1099 contractors than employees, have your client provide facts to support these workers have a legitimate and independent business i.e. EIN, business entity, website – something to establish a legit business. 

EDD and IRS typically look under one the following expense categories for contractors to identify contractors that paid by a business: 

  • Schedule C: “commissions and fees”; “contract labor”; or “Legal and professional”; 
  • 1120S (S corp) and 1065 (LLC): typically find these are reported under COGS or under “other deductions” with a label such as “outside services” or “contractors.”

If you prepare a business return where the business has, for instance, 10 independent contractors and only 2 employees (i.e. where the business owners are also officers of the corporation), you should spend time with the company’s management team to analyze whether the 1099 contractors are legitimate under your state’s law and federal law. 

California recently passed a new law called AB5 (effective as of 1/1/2020) that changes the analysis of a worker’s status. AB5 now has a 3-part test that is more difficult for companies to satisfy. 

You will want to review your client’s general ledger and confirm they are properly reporting ALL 1099s. You should confirm that every independent contractor who provides services (over $600) receives a 1099. If one is missed, the Employment Development Department (EDD) may extend a 3-year audit to 8 years and assess an additional penalty, where the penalty may be higher than the tax.

When reviewing the general ledger, confirm the payees are truly contractors and not workers that should be reported as employees.

3: If your client is selling a business, the buyer will require the current owner to produce a “tax clearance certificate” from the California Department of Tax and Fee Administration (CDTFA), the agency responsible for collecting and regulating sales tax in California.

We have had numerous audits that commenced during escrow, possibly a result of the Tax Clearance Certificate application that was filed with the tax agency. So, you may want to review your client’s general ledger and confirm that the amount of sales tax reported and paid to the state is accurate and the proper correct sales tax rate was used (that includes both local and city tax), as well as confirming that exempt sales are truly exempt.

4: If your client applied for a PPP loan, and receives a request for information and documents from their bank to substantiate their financials, consider calling a tax attorney to review SBA’s regulations and any questions from the bank. 

The Small Business Administration (SBA) is currently investigating all SBA Payment Protection Program (PPP) loans, regardless of the dollar amount of the loan.

Based on information obtained from SBA, once a request has been made for additional documents following the funding of the loan, there is an active investigation. The response from you, the CPA, and your client will affect whether the case is referred to for potential criminal investigation. This would be the case when the information simply does not support the financials or the requirements of the PPP loan.

Issues that have come up in some of our cases include: 

  • Not having a legitimate work visa
  • Using PPP funds obtained by one company that another company applied for and obtained through SBA

5: There are significant benefits to a CPA working with our firm. Some include the following: 

  • Our law firm does NOT prepare tax returns. We work with CPAs referring clients who need a business/personal tax return.
  • We typically have joint representation during an EDD or IRS audit.
  • We also handle criminal tax investigations to protect you and your client. AS you well know,  your communications with an IRS Criminal Investigator are NOT protected by any privilege. However, having an attorney represent your client will ensure the communication and evidence your client provides is protected.

Additional Information and Best Practices

Understanding the Audit Process

  • Audit Triggers: Common audit triggers include significant discrepancies between reported income and third-party reports, unusual deductions, and patterns inconsistent with industry norms. Being aware of these triggers can help in advising clients on how to avoid them.
  • Audit Types: Different types of audits (e.g., desk audits, field audits) have varying levels of complexity and scope. Understanding these can help in preparing clients more effectively.

Implementing Proactive Measures

  • Regular Reviews: Conduct regular reviews of your clients’ financial statements and tax returns to identify and rectify potential issues before they become audit triggers.
  • Internal Controls: Advise clients to implement strong internal controls and maintain detailed records to ensure accuracy and reduce the likelihood of errors that could lead to an audit.

Client Education

  • Training and Workshops: Offer training sessions or workshops to educate clients about tax compliance, common audit risks, and best practices for record-keeping.
  • Resource Guides: Provide clients with resource guides on maintaining proper documentation and staying compliant with tax laws and regulations.

Maintaining Open Communication

  • Regular Updates: Keep clients informed about changes in tax laws, audit procedures, and compliance requirements. Regular updates can help clients stay ahead of potential issues.
  • Feedback and Improvement: Encourage clients to provide feedback on your services and use it to continuously improve your audit risk management strategies.

Legal and Regulatory Changes

  • Stay Informed: Keep up-to-date with changes in tax laws and regulations that could impact your clients’ audit risk. Subscribe to industry newsletters, attend professional seminars, and participate in relevant training to stay informed.
  • Compliance Checklists: Develop compliance checklists for clients based on current regulations to ensure that they are meeting all requirements and minimizing audit risks.

At Milikowsky Tax Law, we have over a decade of experience working with IRS and tax audits. We’re experts in defending business owners in the face of IRS or other government agency audits.Interested in learning more? Read on to learn how to respond to an IRS audit.