Every business owner needs to be prepared for an audit, but what are the most common tax preparation mistakes to watch out for that can actually trigger an IRS audit for your business? These 5 audit red flags will help you properly prepare your books and keep the IRS’s interest off of your return.
What is an IRS tax audit?
A tax audit is an investigation conducted by the IRS in order to verify that the information you’ve entered on your tax return was accurate and correct.
There are three types of audits that are typically conducted.
- Mail Audit - additional documentation requests from the IRS that a taxpayer will receive and respond to via mail.
- Office Audit - in-depth, in-person interviews conducted by audit officers at a local IRS office.
- Field Audit - very in-depth, in-person interviews conducted by IRS agents at your or business.
How does the IRS determine who will get audited?
The IRS decides which businesses will be audited via both random selection and electronic screening selection. Small businesses, such as sole proprietorships, are more likely to be audited than corporations. This is because incorporating your business shows the IRS that your business has a certain degree of financial organization and competence, which makes them more likely to trust your tax return.
It is important to note that if your business is selected for an audit, the IRS will only notify you via US mail. Any other method of communication, such a text message or phone call, is not standard protocol for the IRS.
How many businesses get audited by the IRS?
According to the IRS, 2.5% of businesses are audited each year.
Keep in mind that your tax return is subject to an audit any time within six years of its original filing, though generally the IRS only investigates returns filed within the last three years.
What triggers an IRS audit?
Reporting a net loss on your business
Of course, you can claim a loss for your business for one year if you are usually making profit. However, if you run a full-time business and report a net loss for three out of the last five years, it is likely that you will raise some red flags with the IRS. This is especially relevant to businesses structured as a sole proprietorship, which tends to be the most commonly audited type of business. If your business is consistently failing to make a profit, the IRS will wonder if it is better to classify it as a hobby.
Businesses that are heavily run on cash transactions, such as restaurants, will be under closer watch by the IRS. These businesses are more inclined to an IRS audit as they are more likely to be under-reporting their taxable income, either intentionally or unintentionally. If cash is the backbone of your business, it is crucial to be very precise and detailed in recording your transactions. Remember, under the United States Bank Secrecy Act, many businesses are legally required to notify the IRS receiving a cash transaction over $10,000. If you make a deposit over this amount, the IRS gets notification, so you should be prepared to account for the transaction when filing your return.
A tax return filled with clean, round numbers is a bit suspicious to the IRS. Remember not to make guesses and averages on your return, as this is one of the easiest ways to ask for an audit come tax time. According to the IRS, is It is okay to round up the nearest dollar, but rounding to the nearest 5, 10, or 25 dollar increment from memory or guess is a no. You should aim to always be filling out tax forms in decimal points, especially when regarding expenses and earnings.
Specific business tax deductions
The home office deduction has become a notoriously feared audit trigger for business owners due to its complex guidelines. According to IRS 587, business owners working from home should be using their home office “exclusively and regularly” as your principal place of business, or exclusively and regularly as “a place where you meet or deal with patients, clients or customers in the normal course” of your business. This doesn’t necessarily mean that you exclusively work from home, however, but rather that the space in your home is dedicated exclusively to home office use. It’s wise to consult with a professional tax advisor for the best way to navigate this deduction in order to avoid a potential misstep and trigger an audit for your business.
Often times, tax audits are prompted by beliefs of a taxpayer’s personal vehicles being used for business needs. If you are claiming 100 percent business use of a vehicle, the IRS will likely be auditing your return to more thoroughly check these claims. An audit officer will expect evidence regarding all of the trips that you’ve made throughout the past year with this vehicle, so careful recording of mileage, the clients or potential clients you are meeting with, and the reason for the meeting is essential the event your business is audited.
Client entertainment is an often overused and abused business expense and deduction in the eyes of the IRS. After the 2017 Tax Cuts and Jobs Act, rules have changed regarding what is permissible and possible to deduct, so it can be tricky to navigate. Remember, the general rule is that regarding client meals, 50% of the cost is allowed. The IRS states that an expense must be “ordinary and necessary”, which means that lavish or luxurious expenses could get you on the audit list. It’s important to keep all receipts, a record of dates and times, a detailed description of the expense, and the business purpose and business relationship of the client in order to have essential information at hand need be in the time of an audit.
Failing to report all income
It may seem simple, but many business owners gloss over sources of income that leads them to trouble come tax time. Taxpayers are expected by the IRS to report all income made in the United States, which includes funds being held in offshore bank accounts or cash payments, no matter their size Business owners should also avoid commingling whenever possible. Mixing business and personal expenses is a surefire way to run into confusion when it comes time to file, making it likely to make an error or omission in income.
How do I prevent my business from getting audited by the IRS?
The easiest way to keep your business from an audit is to keep organized, precise records and to be 100% accurate when filling out your tax return. Be absolutely sure that you report the correct deductions, report all sources of income, and consult with an accountant to be sure that your tax return is correct and error-free.