As a diligent business owner, avoiding an IRS audit is undoubtedly high on your priority list each tax season. Navigating the intricacies of tax obligations and avoiding an audit requires an understanding of the triggers that often alert the Internal Revenue Service. By implementing smart tax preparation practices, you not only streamline your business’s tax return process, but significantly minimize the risk of attracting unnecessary and often meticulous IRS scrutiny. In this article, we’ll lay out practical steps and proactive measures you can take to ensure you’re compliant.
What Is Most Likely To Trigger An IRS Audit?
Tax audits can be triggered by various factors, some of which might not necessarily suggest wrongdoing. For businesses, the following elements are often red flags that may increase the chances of undergoing an audit:
- Discrepancies Between Reported Income and Actual Income: If there’s a mismatch between the income reported on your tax return and the income reported to the IRS by clients, banks, or other third parties (on forms like 1099s and W-2s), this inconsistency can trigger an audit.
- Consistent Losses: Reporting losses year after year might be seen as a red flag. The IRS may suspect that the “business” is more of a hobby aimed at creating tax write-offs rather than a legitimate profit-making venture.
- High Income: Businesses that report exceptionally high income relative to previous years or compared to industry averages might attract IRS attention. High income naturally invites more scrutiny.
- Large Deductions: Claiming large deductions that are disproportionate to your business income can be a red flag. The IRS knows the average deductions claimed by businesses in various sectors and may investigate outliers.
- Home Office Deductions: While many businesses legitimately claim a home office deduction, this deduction is often misused, making it a point of scrutiny. Be prepared to substantiate the exclusive use of space for business purposes.
- Highly Cash-Based Business: Businesses dealing primarily in cash (like restaurants and retail stores) often undergo more audits. The IRS is aware that cash transactions can be underreported.
- Classification of Workers: Misclassifying employees as independent contractors to avoid payroll taxes can draw the IRS’s attention.
- International Transactions and Offshore Accounts: Engaging in international transactions or having offshore accounts can increase audit risk due to complex international tax compliance issues.
- Frequent Amendments to Tax Returns: Repeatedly filing amended returns can raise suspicion as it may appear that your business is engaging in improper tax planning or evasion strategies.
- Lack of Consistency: If your tax return lacks consistency with previous years without a clear explanation for changes in income, expenses, or deductions, it may raise eyebrows at the IRS.
What Actions Can You Take To Help Avoid Your Business Being Audited?
Avoiding a business tax audit largely revolves around meticulous record-keeping, compliance with tax laws, and adopting smart tax preparation practices. Below are 12 essential steps to minimize the risk of your business being audited.
1. Maintain Accurate Records
- Keep detailed and accurate records of all financial transactions including income, expenses, deductions, and credits. Ensure that your financial statements align with your tax returns.
2. Report Income Accurately
- Declare all income received during the tax year. Cross-check the income reported on your tax return with the income reported on 1099s and W-2s received from clients, vendors, or third parties.
3. Avoid Consistent Losses
- As we’ve mentioned, reporting losses year after year raises red flags. Ensure that you can substantiate your losses with proper documentation and valid reasons.
4. Claim Deductions Judiciously
- While deductions can significantly reduce tax liabilities, excessive or unusual deductions can attract IRS attention. Be conservative and honest with your deductions, and always have documentation to back them up.
5. Use Tax Preparation Software Wisely
- If you opt to use tax preparation software, select a reputable program that is updated regularly to reflect the latest tax codes and laws. Using software can help avoid calculation errors.
6. Classify Employees Correctly
- Misclassifying workers (as independent contractors instead of employees, for instance) is a common audit trigger. Understand the IRS guidelines for classification and adhere to them.
7. Be Consistent
- Consistency in reporting from year to year is crucial. Any significant changes in income, deductions, or business practices should be well-documented and substantiated.
8. File on Time
- Late filing can draw attention to your return. File your tax return on time to avoid penalties and unwanted scrutiny.
9. Respond Promptly to IRS Notices
- If you receive any notice or request for additional information from the IRS, respond promptly and accurately. Ignoring notices can lead to further investigation.
10. Conduct Internal Reviews
- Regularly review your business’s financial statements, tax returns, and supporting documentation to identify and rectify any discrepancies or errors before filing.
11. Stay Informed
- Keep up-to-date on the latest tax laws, regulations, and compliance requirements. Being knowledgeable can help you take advantage of tax benefits while avoiding practices that could lead to an audit.
12. Hire A Professional
- Engage a Certified Public Accountant (CPA) or tax advisor with experience in business taxes. Professionals can provide invaluable advice and assist in preparing accurate returns.
What Happens If You Do Get Chosen For A Tax Audit?
A tax audit involves the IRS or another tax authority closely reviewing your tax return to verify its accuracy and compliance with tax laws. The process varies depending on the type of audit: correspondence audit (conducted by mail), office audit (in-person review at an IRS office), or field audit (at your home, business, or accountant’s office).
You’ll receive a notice indicating you have been selected for an audit. The notice will specify which tax return year is under examination and what documentation you need to provide. This is when you’ll want to gather and organize all relevant documentation that supports the entries on your tax return. This might include receipts, bills, legal papers, and logs.
The tax auditor will review the provided documents and might request additional information. The extent of the examination depends on the audit type. For simple issues, it might be a quick process, but for complex situations, it could take several meetings. After reviewing the documentation, the auditor will make a determination. There can be three outcomes:
- No Change: If everything is in order, there will be no changes to the tax return.
- Agreed Changes: If there are discrepancies, and you agree with the proposed changes, you might owe additional tax.
- Disagreed Changes: If you disagree with the proposed changes, you have the right to appeal the decision.
If you owe, you are expected to pay the additional tax assessed. If you disagree with the outcome, you can file an appeal with the IRS or possibly take the matter to tax court. Once the process is completed and all issues are resolved, the audit is closed. Depending on the result, you may need to make payments, or you might receive a refund if it’s determined you overpaid.
Who Can Help You If You’re Being Audited By The IRS?
In the event that you find your business has been chosen for an audit, remember that assistance is readily available to navigate this daunting process. A proficient tax professional or CPA, like our experienced team at Minton CPAs & Associates, stands as an invaluable ally, offering representation, guidance, and expert counsel during an IRS audit.
Leveraging extensive knowledge and a deep understanding of tax laws and audit processes, we are equipped to advocate on your behalf, ensuring your rights and interests are protected at each step. We’ll also be here to help you take preventative measures with our tax preparation and tax filing services, designed to safeguard against audit triggers while optimizing your tax position.
Have questions? Reach out to us today at 757-546-2870.