Although the chances of an audit are rare, the fact is tax audits are a fairly routine business for the IRS. That said, audits can be especially scary for small business owners. After all, there are certainly horror stories in which IRS audits have resulted in company closures.
Fundamentally, an IRS audit is an evaluation of your business’s financial accounts and information. As such, you'll find most audits are a result of discrepancies on tax returns. The IRS is simply reviewing your entries to ensure everything is in order. Sometimes an audit is random, and other times it can be based on suspected suspicious activity.
So, here are some red flags that could trigger an IRS audit of your business.
The more manual your accounting and expense management functions are, the more likely you are to make errors when filing your taxes. Your accounting system is crucial to understanding business performance and is also vital to tax preparation.
While most accounting functions are digitized nowadays, data entry blunders like treating expenses as income or duplicating an entry could trigger a letter from the IRS. An audit can be triggered by something as simple as misspelling your business name. This is where e-filing comes in handy because you can load vital information from past tax returns.
If your math is a little shaky, soliciting the services of a tax preparer near you could save you the headache of an IRS audit.
Underreporting your income on your tax return is a top audit trigger. The IRS compares your income from one tax year to the next. A noticeable discrepancy without supporting information can make Uncle Sam sit up and take notice.
The IRS wants what it’s owed and will go to great lengths to verify the reported amount of tax is correct according to tax laws. So, it's only a question of when before it spots your omission. This is especially true for cash-heavy businesses like barbershops and nail salons.
It's not uncommon for small business owners to have itemized deductions on their returns, like home office deductions. While these tax deductions can reduce your taxable income, they can also raise red flags when they don’t measure up to your income. Same case if you’ve made significant contributions to charity.
The IRS also compares your tax returns to those of other businesses in your industry – anything that’s out of the ordinary may subject you to further scrutiny.
The IRS stipulates that a business expense has to be both ordinary and necessary to qualify as a deduction. For instance, a professional painter could claim paint and paintbrushes as business expenses, but a software engineer who paints as a hobby cannot.
If you have large expenses, it’s pertinent to keep all your receipts in case you are asked for verification. However, matters get a little more complicated when it comes to entertainment, travel, and meal expenses, as they may blur the lines between personal and business expenses.
One in 100 businesses get audited each year, and usually the ones that earn more than $1 million per year, especially if they report a significant change in income. It's not unheard of for companies to start raking in millions in revenue seemingly "out of the blue", particularly in the age of social media when branding has a direct impact on your bottom line.
Don’t be surprised if you hear from an IRS agent when you start showing a substantial increase from year to year. That’s also a great time to bring in a business advisor to develop a growth strategy.
If you claim a business loss each time you file a tax return, you may be due for a tax audit. While it’s not uncommon for small businesses to have losses, having many years of Schedule C losses could have the IRS questioning the legitimacy of your business. If you don’t turn a profit, the IRS may consider your business a hobby which could limit your tax deductions.
Keep all your business documentation that shows your company's revenue and expenses throughout the year to cover all your bases.
Unfortunately, the IRS tends to scrutinize self-employed individuals, especially if they fail to report a profit for at least three out of five years. This applies to freelancers and anyone working in the gig economy as well. Yet again, the IRS could claim your business to be a hobby, which would disqualify you from claiming certain business deductions.
As a small business owner, you should consider forming an LLC to lower your audit risk. Consult a tax professional near you to determine which entity would work best for you.
Some businesses intentionally misclassify employees as part-time workers or independent contractors for several reasons:
It's important to classify your employees appropriately and keep documentation of any independent contractors you hire.
Talk to BAAP CPA about your accounting practices, income, or deductions to determine what could trigger an IRS audit. We're a CPA firm in Clearwater offering business advisory services designed to help you understand your business better and keep you on Uncle Sam’s good side.
Contact us for comprehensive tax preparation services and any questions you might have.