Understanding the process will keep you cool under the auditing microscope.

From the files of truth is stranger than fiction: We once had to postpone an Internal Revenue Service audit of a client because our client suffered a heart attack upon receiving the notice of audit. Needless to say, our client overreacted. If you understand the auditing process and how to prepare for an audit, you will see that there is no reason to be that anxious.

First, be comforted by the fact that audits continue to be relatively rare. Less than 1% of all business tax returns are audited. In 2007, less than 60,000 businesses were audited in the entire country. However, audits continue to be an important compliance tool. The IRS collected an additional $59.2 billion of revenue in 2007 as a result of audits, both business and personal.

Generally, the selection of businesses for audit is not random. The IRS has developed various computerized tools for selecting audit targets. Some corporate tax returns are processed through the IRS’ Discriminant Inventory Function system (DIF). This program assigns a score to each processed tax return based upon the amount and nature of deductions that have been taken. A high score under the DIF system means that there is a high potential that an examination of the return will result in a change in the taxpayer’s income tax liability.

Other tax returns are selected for audit because information from third-party documentation, such as Form 1099s, does not match the information on the taxpayer’s return. Additionally, the IRS will, from time to time, decide to investigate the questionable treatment of a particular deduction and audit taxpayers who have taken such a deduction. Finally, the IRS sometimes selects tax returns in order to study the behavior of similar taxpayers (a particular industry or a market segment) with respect to particular tax issues.

The IRS has developed different types of audits for different purposes. Increasingly, the IRS is using a “soft” audit technique. This typically involves sending a letter to a taxpayer requesting information regarding a specific tax issue or item on a tax return. The taxpayer is asked to respond and the entire audit is handled through the mail.

If the examination of your return is more involved, an IRS agent will send a letter requesting a time and place to conduct an examination. The examination can be held at your home, your place of business, an Internal Revenue Service office, or the office of your attorney or accountant. The letter from the IRS also will include a list of records that will need to be available to the agent.

First, you need to decide who should handle the audit on your behalf. While it is not necessary to involve your accountant or tax advisor, the law permits you to have a representative handle the examination on your behalf. If you anticipate problems during the examination, having a tax professional involved from the beginning is probably a good idea.

Next, you need to assemble all of the requested records. We recommend organizing your documents in the order requested by the agent. If possible, anticipate where the agent may have additional questions and have additional documentation or explanations ready to respond to those questions.

If the examination is to be held at your place of business, find a location for the agent to work where he or she will not be interrupted or distracted and will not have contact with your employees. Occasionally, an agent will attempt to speak with employees as part of a fishing expedition. You are not required to give the agent access to your employees, and you should not.

Some time after the audit is complete you will receive a letter from the examining agent. That letter will state either that there are no changes or that there are certain proposed changes to your return. If you agree to the proposed changes, the examination will be closed. If you do not agree, there are various procedures for appealing the agent’s determination. The appeals process is a bit complicated, and you should seek professional help before beginning the process.

If you happen to be among the 60,000 businesses that will be audited in 2008, don’t panic. Make certain your paperwork is in order and consult with your tax professional. Chances are good that the audit will be much less painful than a heart attack.

Michael P. Coyne is a founding partner of the law firm Waldheger Coyne, located in Cleveland, OH. For more information of the firm, visit: www.healthlaw.com or call 440.835.0600.