What triggers a small-business audit? The truth is that quite a few things do, though if you’re prepared, being audited as a small business doesn’t have to become a major stressor. Click through to understand what the IRS sees as red flags, so you can try to avoid an audit — or at least be prepared in the event that your small business is audited.
Are you worried about the likelihood of your business being audited by the IRS? If so, there are a lot of preventive red flags that you can keep an eye out for when looking to protect your business from being the focus of an audit.
- Inaccurately reporting your annual income: Every year, you will submit a Schedule C form, which denotes the income you report for the prior tax year. If you have incorrectly reported the amount of money that you earned in a given year, the likelihood of your being audited by the IRS will increase as a direct result of your inaccurate claim. As such, it is imperative that you report your income accurately — down to the penny. Refrain from rounding, omitting a portion of your income or stating that you either earned more or less than you truly accrued in the tax year in question.
- Making deductions that are disproportionate to your reported income: As a business owner, you will likely be able to benefit from itemized deductions and common tax deductions that are common amongst business owners of all business sizes, such as the home office deduction or deductions pertaining to the use of vehicles for business-related purposes. However, if you try to claim a lot of business deductions, the IRS may find it suspicious and audit you as a result of the red flags raised. In order to claim an expense as a business deduction, it must be both ordinary and necessary, meaning your expenses are related and applicable to your business operations.
- Claiming that you had a large number of expenses: If you spend a lot of money or you drastically alter your expenses year over year, this behavior may prompt an audit from the IRS. For example, business expenses that are deemed excessive or unreasonable would be if you were to claim that all your meals during your workdays are business expenses.
- Denoting a high amount of cash transactions: There are many business types that rely on cash, as well as profits, as a primary source of revenue. However, as a result of this and due to the nature of cash in that it is not documented the same way digital transactions are, the IRS may believe that you underreported income simply because it is easy to do so when cash is such a common form of payment for your business. You will need to be able to verify your income, so even if you handle cash often as part of your business transactions, do your part to prevent an audit by always documenting your transactions, both physically in the form of cash and digitally in the form of checks or credit cards.
- Claiming business losses from the past in the present: If you claim the same business loss every time you file a tax return from one year to the next, the IRS is more likely to audit you because this will be viewed as suspicious behavior. While it is not uncommon for losses to occur, especially in the context of a small business, reporting either the same loss every single year or claiming multiple years’ worth of losses can cause the IRS to question the legitimacy of your business as well as you as a business owner. As always, make sure you have proper documentation that depicts your revenue and expenses throughout the year.
- Falsely classifying your employees: Be especially mindful of how you classify your employees, and make sure you do not falsely report them as being independent contractors. In the eyes of the IRS, an independent contractor is someone who controls what they will do in terms of work, how it will be done and how much money they are willing to do said work for. Independent contractors vary greatly from employees, and as such, you cannot decide to reclassify someone who is an employee as an independent contractor for tax purposes. Always maintain important documentation regarding the work that your independent contractors do for your business and keep that information separate from the documentation pertaining to your employees.
Returns are often selected for audits as a result of errors that the IRS has pinpointed within them. Most tax audits will take place within a year after the tax return was filed, and typically, audits take less than a year to complete. However, you can certainly take measures to shorten the timeline of an audit, starting with the prioritization of preparing your documentation and responding promptly to questions or requests from the IRS.
What to do in the event of an audit
If you are notified that the IRS plans to audit you in the near future, here is what you can expect moving forward:
- Known as a field audit, most IRS agents will carry out business-related tax audits in person.
- In most cases, business audits will be comprehensive, meaning they will cover issues relating to employment taxes and income taxes. A field audit takes an extensive look into documented records pertaining to your business as well as your accounting system. The IRS will conduct an array of tests that are designed to determine the accuracy of your reported income. When you are prepared for the interview that coincides with the audit, the process will unfold far more easily and quickly than if you go into the audit completely unprepared.
- While you are being audited, the IRS agents will ask you to provide information and documentation that explains your position as denoted in your business tax return. You can incorporate the insights of a licensed tax professional to assist you in relaying facts and figures to the IRS as you work with the agents. A tax professional can serve as an advocate for you over the course of the audit process.
- Ultimately, the IRS will decide when it is time to finalize the audit and close the case pertaining to your business. Whether the IRS agents state that no changes must be made, or the agents request that you make applicable adjustments to your business return, you will usually have a 30-day period during which you can appeal the IRS’s requests in the event that you disagree with the outcome of the audit.
Approximately 2.5% of all U.S. small-business owners are audited by the IRS. To adequately prepare for the possibility of being audited someday, keep meticulous records of all tax-related transactions and work with a professional who has experience handling IRS audits when they arise.