Audits can be a very scary experience, especially for small business owners. However, there are several things you can do to make the audit less frightening.

The place to start is several years before an audit occurs. You should keep good records, including canceled receipts and checks along with bank statements. Keep all records for 7 years.

The most important item to document is revenue. Many of the audit techniques are focused upon finding unreported income. You should have a separate business checking account, even if you are a sole proprietor. All receipts should be deposited promptly in the bank. Clearly mark any shareholder or other loan proceeds as such, since the IRS will assume all deposits are revenue unless indicated otherwise.

If you are a retail establishment, keep the "Z" tapes each day. For other businesses, you should use pre-numbered invoices to bill customers. If the invoices are not pre-numbered, the IRS might assume that there are unreported invoices that you held out. If the numbers are pre-printed, the agent can see that every number is accounted for. Keep any voided invoices, otherwise the IRS agent will assume that missing invoices represent unreported income, usually calculated as the average amount on other invoices.

The IRS will also compare bank deposits (for both personal and business bank accounts) to invoices or "Z" tapes. Any discrepancy (either deposits greater than invoices, or less) will be counted as unreported income. Therefore it is very important to account for all the billings and collections.

Agents will look for you to match up two things to allow deductions. You must show that the item is a legitimate business expense (the bill will prove this), and proof that you paid it (such as a canceled check or cash receipt).

Be prepared to explain big deductions. Travel, entertainment, automobile usage and home office expenses are especially suspicious to the IRS. To get the auto expense, you must keep an auto log (which you can buy from any office supply store). If you own the car, you must document business miles. If the company owns the car, you must document the personal miles, which will be used to determine the amount of corporate car expense that will be disallowed on the return.

Beware of S-corporation distributions. Since these distributions save payroll taxes, the IRS will look for a reasonable relationship between profit distributions and wages. Declaring no wages is a big audit flag, since it is not believable that you could find anyone to work hard running your company all year for free. In general, the IRS will look at whether you are the highest paid employee, and whether the distributions are greater than twice the wages. Of course, if you don't take distributions, then the wage level doesn't matter (such as when there is little to no profit).

Classify workers properly. In many parts of the country the IRS has made more money on "independent contractors" who failed the 20 point test than they get on income taxes from smaller businesses.

Be sure to file all information returns. The 1099s can cost you stiff penalties if you ignore them. Also, don't ignore barter income. For example, if you traded some of your services for a weekend at a client's hotel, you would have taxable income, and the hotel expense would be considered a personal non-deductible item. Therefore you would be considered to have unreported income.

How should you act in an audit? First, involve your accountant as soon as you get the first notice. Better yet, let the agent conduct the audit at your accountant's office without you. If you do choose to meet with the agent, be polite and always answer truthfully. If you do not know the answer, let the agent know that too. Any sarcastic, angry or evasive answers will only anger the agent and arouse suspicion. For your own protection, keep all answers short and to the point. Do not be lead into discussions where you may say something that is misunderstood or causes the agent to expand the audit.