Here's how we prepared, what we did right, and how it went:

Our returns were "flagged" by the IRS because my husband, Doug Plummer, has a home office and $20,000 of travel expenses, and because I never gave 1099's to my three consultants, and because of our two rentals (one of which is my office.)

We did several things right:

  1. We immediately called our great accountant, Christina Anderson, who told us how to prepare, held our hands through the process, and represented us at the actual audit.
  2. We already had good records, easily pulling 2007 files out of storage.
  3. We had separate bank accounts and Quicken accounts for each financial entity: one for the rentals, one each for the businesses (my psychotherapy business and Doug's photography business) and we each have personal accounts. So if you are running your business account out of your personal checking account, get yourself another checking account, this minute. If you don't have Quicken or something similar, get yourself a computer-based accounts manager. We printed multiple reports while preparing and even ran some that the auditor requested while he was here.
  4. The auditor sends you a list of what he or she wants. We pored over the list, compiling receipts, making Quicken and Excel reports with receipts attached, for everything that the auditor asked for. We put each requested thing in its own clearly marked file, since auditors may work for hours without the tax-payer in the room.
  5. We were welcoming and friendly to the auditor, as a guest in our home. He couldn't accept food or coffee, but we provided water, showed him the way to the bathroom, and made sure he had a comfortable chair and an expanded dining room table to work on. We worked collaboratively with the auditor to get him the information that he needed to do his job. Later, our accountant told us that some people start out hostile or defensive with auditors and get the same back. Our auditor agreed. If people are hostile, he assumes they are hiding something. We had a pleasant time, considering the circumstances. It didn't hurt that he was half our ages and baby-faced cute. (No, I didn't pinch his cheeks.)
  6. We didn't give the auditor more information than he asked for. We admitted when we didn't know something or had no documentation.
  7. Doug, who travels for a living, has written a detailed blog post about how to document travel expenses:  
  8. He wrote another post about the audit day:

What I did wrong:

 I had no idea that we are supposed to issue 1099's to other professionals we pay. I had a few thousand dollars of expenses, split between 3 consultants, and I should have issued 1099's to each of them, and 1096 forms to the IRS about them. And, no, you can't declare your personal psychotherapy to be consultation. And it's only for people you paid more than $600 in one year. If you pay rent for your office, you must issue a 1099 to your landlord. It's supposed to go in by Jan 31 of the next year. I'm working on the 2009 1099's right now. 

My 25 consultees and 4 office tenants have never given me 1099's. It doesn't effect me, but it will get them dinged in an audit. I'm paying the not so horrible penalty of $50 for every 1099 I didn't issue in 2007 and 2008, about $300.

Total cost:

We paid our accountant about $900 for helping us prep and then being with us for some of the audit. We lost two days of work each, for the audit. And about 40 hours each in preparation. And I owe about $300 in penalties. It could have been worse.

So, keep good records, issue 1099's, have Quicken or the equivalent, have separate accounts for personal and business, and don't throw anything out. Hire an accountant, we couldn't have done it without one. And I hope all my readers can avoid audits forever.