10 Tips to Avoid an Audit on Your Small Business

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"Audit" is the one word that no one wants to hear, and you've probably spent a bit of the tax season trying to figure out how to avoid an audit on your small business. It doesn’t matter how well your records are kept — it’s always a headache. Let’s be honest: Some of us don’t keep records as tidy as they should be. If you’ve been particularly reckless, you might find yourself facing some serious criminal charges.

It may seem like tax audits are random, and some of them are, but you can avoid them to some extent. It's important to know the IRS red flags and to prepare your records properly to prevent a full-on disaster.

What Is an Audit?

When small-business owners mention an audit, they’re mostly thinking of financial audits. There are three types: an internal audit, an external audit and an IRS audit.

  • Internal audits are done within a company to double check finances and streamline processes.

  • External audits are done by an external auditor who is usually reporting to an organization. You might see this in the case of a business needing a certain permit or insurance.

  • IRS audits: This is the big one by the U.S. Internal Revenue Service. For this type of tax audit, IRS auditors will look at your tax return and make sure it actually matches your company’s finances. 

Most small businesses are focused on IRS audits because they have the opportunity to be devastatingly expensive. Tax law is complicated, but any tax professional should be able to help you identify audit triggers. Some are avoidable, while others may not be avoidable depending on the type of small business you run.

Who Gets Chosen for an IRS Tax Audit?

The IRS’s process for choosing who gets audited isn’t always random, though sometimes it is luck of the draw. For everyone else, the IRS will use a computer program called the discriminant income function that compares your tax deductions and reported business expenses to other tax returns in your tax bracket. If something unusual sticks out, you might be audited.

Some small businesses are also more frequently audited than others. This includes self-employed individuals who are filling out a Schedule C form and people who make most of their money through cash transactions, like waitresses, hairdressers and child care workers. The IRS also scrutinizes highest and lowest earners. Taxpayers who make more than $1 million a year or those who are in a very low income bracket are at a higher risk, but only about 0.7% of tax returns are audited overall.

How Does an Audit Work?

The IRS has a number of different kinds of audits, but two of the most common are correspondence audits (the most basic) and field audits (the most extensive). During a correspondence audit, the IRS will send you a letter outlining the concerns, and you’ll be able to respond with supporting documentation like bank account and credit card statements.

Field audits are generally more complicated. An IRS agent will physically comb through all of your financial and bookkeeping records to try and get a full picture of your business’s finances. They may even interview employees and look at your personal finances. For this type of audit, you should hire a tax attorney. Thankfully, there are some things you can do to limit your chance of an audit before it happens.

1. File Your Return

If you're wondering how to an avoid an audit of your small business, here's one tip: actually file your return. Many people think they don’t have to file a return because they didn’t make any taxable income during the tax year. It’s true that you don’t have to file a return on some occasions, but it does raise a red flag for the IRS. Even if your business is at a loss, you should still file a return that explains why you don’t have any taxable income.

2. Sign Your Return

The number of people who forget to sign their tax returns is absolutely shocking. Don’t get audited on a silly error. This is a huge tip-off to the IRS that maybe the figures in your return are also incorrect.

3. Incorporate Your Business

The IRS loves to audit self-employed individuals who are likely to write off personal expenses as business deductions or make mistakes. Remember: Whatever you write off for business purposes should be an actual business expense. Even a home office deduction — something you genuinely do use for business — can raise a red flag.

The best course of action for independent contractors or sole proprietors to avoid an audit is to incorporate or form an LLC. These types of business structures are audited by the IRS less frequently and bring additional tax deductions. If you file a Form 1040-EZ, pay rent rather than own a home and don’t have children, it’s extremely unlikely you’ll be audited unless you’ve made a mistake.

4. Check Over Your Tax Return Twice

One of the main things that raises a red flag to the IRS is an error on a tax return. You should always, always check over your return before you send it to make sure that your tax forms match your returns and that there are no mathematical errors. It’s also extremely common for people to forget to report a certain form, which may tip off the IRS to a mistake.

The IRS generally scrutinizes the figures on the first two pages. Your taxable income should accurately reflect your business income minus deductions. Using accounting software like QuickBooks dramatically decreases the chance of an error. Only about 0.5% of returns that were e-filed contain errors versus 21% of paper filings.

5. Make Sure Your Deductions Are Realistic

The government doesn’t just look at the figures on your tax return if you’re facing an audit; it looks at your whole financial picture. An unrealistic deduction, such as donating 30% of your income to charity or taking an unusually expensive business trip, can raise a red flag for IRS auditors. In other words: You probably shouldn’t buy a new Mercedes for your company while reporting a loss for the year.

There are a wealth of deductions that small business owners can take, but it’s extremely easy to mess up.

6. Don’t Overdo Home-Office Deductions

The IRS really scrutinizes what expenses are for personal use and which are for business use, which is why home-office deductions can often trigger an IRS audit. That’s not to say that you shouldn’t take the deductions to which you’re entitled; you just need to make sure you’re taking the ones that are appropriate.

For example, any home-office deductions that are too big compared to your income can raise red flags. If you’re making $50,000 at your home-based business but write off $30,000 of rent, that may cause the IRS to investigate. The same thing goes if you’re trying to write off that new flat-screen TV you bought.

You should hire a tax professional or accounting firm to help you with your small-business tax return if you have a lot of home-office deductions.

7. Mind Your Losses

Yes, most small businesses take some time to become profitable, but sole proprietors filing a Schedule C will also come under scrutiny if they’re reporting losses for more than three years in a row. In order to avoid any problems, you need to be able to back up your deductions with proof that your business is actually a business. Remember that the IRS is trying to find fraud, which includes businesses being used to launder money and reap the benefits of shady deductions.

Even if you’re not filing a Schedule C, losses still raise a red flag. About 3.25% of tax returns with no adjusted gross income were audited in 2016, which is well above the average .07% of taxpayers who are audited in general.

8. Avoid Suspicious Numbers

Not all numbers are equal, and some can trigger an IRS audit. Basically, you want to avoid doing anything that looks suspicious, which shouldn’t be difficult if you are in fact not doing anything suspicious. Believe it or not, round numbers are a big red flag. Be aware that deductions that end in round numbers may tip off the IRS, so you’ll need the proper receipts to back them up.

9. Don’t Overestimate Donations

If you’re self-employed or a sole proprietor, your personal donations are mixed with your business income on your tax return. The IRS loves to see donations, but they are suspicious of people inflating the value of donated goods. Generally, the value of a donation should fall between 1% and 30% of the retail price of an item. An appraisal is often required for items worth $5,000 or more, so make sure you can back up donations with paperwork.

10. Don’t Underreport Income

If you’re someone who is getting a lot of Misc-1099s or cash, it may be tempting to leave some of your income off your tax return. This is a terrible call, even if a business didn’t send you the proper reporting forms. It’s essential that you report all business income because if you get caught, you’ll have to pay back taxes, penalties and interest, not to mention that you’re at risk for a criminal investigation if it’s a significant enough figure, and the IRS believes you’ve underreported on purpose.

Keep Detailed Records Just in Case

Sometimes, an audit is unavoidable because it’s luck of the draw. In order to make an audit easier on your company, you should have detailed bookkeeping records. Good records can easily back up any deduction or income disparity. You may also want to run an internal audit to catch any bookkeeping mistakes before the IRS does.

It’s also important to keep your business and your personal records separate. Have one credit card for personal expenses and one credit card for business expenses. If you’re running a corporation, LLC or partnership, keep business income in a separate bank account and pay yourself a set amount each month.

What Do I Do if I’m Being Audited?

If you happen to be selected for an audit, it’s time to prepare detailed records including a summary of everything you’re sending. Don’t forget any documents the IRS thinks you might be missing or an explanation as to why those documents don’t exist. The IRS typically gives you about 30 days to respond to the letter, but if you don’t, it will generally:

  • Make changes to your tax return (for example, adding the income they thought you omitted)

  • Send you a statutory notice of deficiency with proposed taxes and penalties.

You have 90 days to file a petition with the U.S. Tax Court if you disagree with their amendments. You may want to use the services of a tax professional who can help you prepare your response. If you’re subject to a field audit, you’ll need a tax attorney. At the end of the day, you may just walk away having to pay additional taxes, interest and a penalty.