Surviving a tax audit – a how to guide

(tax audit – 5 minute read)

Oh gosh, the worst has happened! The tax authorities have sent you a letter stating that they intend to audit your tax affairs. Seriously, I can’t think of a scarier outcome for any business owner (or even salaried individual) then getting a tax audit. Heck, even my knees get wobbly at the mention of a tax audit and this is despite my years of good relations with my local tax authorities.

But not to worry! An audit is simply a procedure that is carried according to certain rules. So long as you abide by these rules, you can survive a tax audit. Always remember that – if you’ve done nothing wrong, there is nothing to worry about!

Voluntary disclosure can reduce the scope of a tax audit

When you get the notification of audit, you should immediately file a voluntary disclosure. This means that you get to disclose any of your errors/mistakes before the audit begins.

The idea here is that if you come clean to the tax officers about your mistakes, they don’t have to spend as much time auditing your business. It allows them to focus the scope of their audit and figure out the extent of your mistakes. More importantly it allows them to spend less time auditing your business. Tax officers are busy people. They can’t spend all their time breathing down your neck.

Examples of voluntary disclosures

Example 1: Sara has been offering her cleaning services to clients and is charging them GST (Goods and Services Tax). However, Sara is not GST registered. The tax authorities have declared that they want to audit her tax statements. Upon seeking advice, Sara was told that she should voluntarily disclose that she’s been charging GST when she was not registered for GST. In this case, the tax officers will likely ask for her bank statements and sales invoices. Once they have those, they’ll calculate the amount of GST Sara should return to the tax department. After that, they’ll will very likely ask that she be GST registered and start filing GST returns on the regular.

Example 2: Ahmad has fully claimed the price of a car as a tax deduction in his business. This is the incorrect treatment. It should be on the fixed asset register and depreciation applies to it on a yearly basis. Ahmad’s business was randomly selected for a tax audit. Upon seeking advice, Ahmad was told to voluntarily declare that he incorrectly expenses his car instead of depreciating it. In this case, Ahmad may have to pay some extra tax.

In both cases, the tax authorities will have gotten what they came for, which is tax compliance (and the tax payment). Once they have that they’ll be happy enough to leave your business alone. For now.

Have all your financial records in order

I cannot underestimate how important it is to have your financial records in order. In fact, the best way to avoid an audit in the first place is to have your finances in order, file your taxes and pay them on time. Tax authorities have limited resources and will often focus on entities whom they deem to be ‘problematic’. This can include those who amend their returns multiple times, consistently claim tax refunds in their returns, fail to file or pay on time or have not been filing tax returns for consecutive years.

Of course, you may also be subject to a random audit. But even then, this is typically targeted at a selection of industries whom the tax office has deemed to be problematic. Over here in NZ, industries that have been specifically targeted in the past include real estate agents and building contractors.

Whatever the case is, please have your finances in order. Here are the absolute must-haves in case you ever get a tax audit:

1. A copy of your business’s bank statements (if you are a sole trader, please keep your business accounts separate from your personal accounts).
2. Invoices issued to your clients
3. Receipts/Invoices from your suppliers (especially for large purchases)

If you use an accounting software, this process becomes a lot easier as you accumulate your documentation and have them recorded as you go.

How much detail do you need in a tax audit?

Legally speaking, here in Aotearoa NZ, you need to maintain all financial records for a period of at least 7 years for the tax authorities to access. This includes all invoices, receipts, purchase orders etc. In practice however, I’ve never had a tax officer demand to see the receipt for the $5 business coffee that the client had while they were out networking.

The truth is that the tax authorities have limited resources. They usually won’t waste their time chasing after small transactions. In the few cases where our clients have been audited, the tax officers will typically ask for the purchase invoices worth more than $1,000 for verification. After all, there’s no point in spending more of the taxpayers’ money on a tax audit that will yield very little tax anyway.

In any case, the tax officers will have access to your bank statements. If you’ve been running business transactions electronically, they will be able to see where your money is going from there. In this respect, the bank statement becomes the primary source document that the tax officers will use to conduct their audit.

Cooperate, cooperate, cooperate!

It is important to be as cooperative as possible in a tax audit. Reply to tax queries as soon as you can. Make sure that the tax officers have access to all your financial records. Don’t stall, hide information or obfuscate their work. Remember that the harder you make it for the tax officers, the harder they will make life for you.

After a tax audit – what happens?

After a tax audit the tax officers will come to a judgment about your business. In most cases you will have tax to pay. You may also have to contend with late payment penalties and interest charged to your tax owing. If you have filed a voluntary disclosure, this is the most likely outcome. In the very rare occasion that you overpaid taxes, you will get a refund.

If you have not filed a voluntary disclosure and the tax office finds that you’ve been underpaying your taxes, then one of the following may happen:

1. They will levy an extra penalty against you due to negligence (on top of late payment and interest) and leave a very stern warning for you.
2. They may deem that you’ve been purposefully falsifying your tax returns and charge you with tax evasion. Which is a criminal charge.

Note that ‘1’ will only happen if the magnitude of the offending is low and you’ve filed a voluntary disclosure. Without a voluntary disclosure, you may get taken to court.

Just get an accountant!

Tax audits are stressful. The cost of hiring an accountant to manage your case on your behalf is a lot less than the stress and penalties from a tax audit gone wrong. Furthermore, if you end up being accused of tax evasion, you’ll have to hire a lawyer. Trust me when I say, Lawyers are a LOT more expensive than accountants!

By the end of the day, if you have nothing to hide, then you will come out of the tax audit mostly unscathed. If you DO have something to hide, then you should come clean via a voluntary disclosure. Remember that tax audits are not scary, provided that you do everything correctly!

Stay positive!

Sam