How to Keep Your Small Business From Getting Audited

by Angie Mohr on April 9, 2013
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It’s the kind of letter or phone call that strikes fear in the hearts of most small-business owners: The IRS is contacting you to audit your income-tax return.

There’s no need to panic, however. Although there is no sure-fire way to avoid a tax audit, there are ways to mitigate the stress and pain of one.

What triggers an audit? The IRS may audit anyone’s tax return for any reason. But individuals who report straightforward income and deductions that may be easily verified (with documentation such as W-2s or 1099s) are less likely to pique Uncle Sam’s interest than others.

Just over 1 percent of all returns were audited in the 2012 fiscal year, according to the IRS. Taxpayers with annual incomes of more than $1 million, or people with more complex deductions, were subjected to more audit coverage, at a rate of almost 10.3 percent.

As an unincorporated small-business owner, you are required to file a Schedule C with your personal income-tax return that outlines your business income and expenses. These returns are also subject to a higher level of scrutiny by the IRS, because you don’t submit your receipts and other business records with your return.

The good news is that you don’t have to be fearful of an audit if you follow these tips:

1. Know what you are filing. Keeping up-to-date on the tax laws is difficult. Knowing how depreciation works, how to calculate home office expenses, and how to figure out mileage are not automatic skills that most small-business owners possess. Just because your tax software allows you to enter numbers in various places doesn’t mean they belong there. If you feel like you don’t know how to properly fill out your tax return, it can be worthwhile to hire a tax professional to do it for you. You may be claiming deductions you aren’t entitled to or missing out on some you are. Even if a professional handles your return, you are still responsible for any mistakes or omissions, so it pays to have a basic understanding of the process.

2. Double-check your return before filing. The IRS states that the vast majority of changes on tax returns after an audit are due to mathematical errors. Especially when filling out your return by hand, it is easy to add up a column incorrectly or apply percentages wrong. Using tax software like TurboTax helps to cut down on these kinds of errors, but it can’t prevent them completely. Look over your return to make sure everything makes sense to you before popping it in the mail or e-filing.

3. Keep original documentation for seven years. Most audits are conducted on the previous year’s tax return, but auditors may go back three years if they believe that there are systemic errors in your returns or six years if they believe you have large understatements of taxable income. They can go back in time indefinitely if they think you’re trying to defraud the IRS. Keeping all documentation that supports your tax returns for at least seven years ensures that you can back up any claims. If you have lost or destroyed the documentation, the IRS can disallow your claim and you will have to pay not only the extra tax, but also penalties and interest, which can add up quickly.

4. File amended returns for any errors you notice after filing before you are audited. If you come across an error or omission in your return, correct it right away. Do not wait for a potential audit. File a 1040X return to amend the original. You will still have to pay any extra tax due and interest, but the IRS offers some leniency with penalties for innocent errors. Taking the chance that the IRS won’t find the error will merely add to the stress you likely already have as a small-business owner.

5. Hire an experienced CPA to handle your tax audit. There are several good reasons to get a professional involved in your tax audit. They navigate audits on a regular basis and know what the auditor is looking for. If the audit is complex or involves scans of bank accounts and other invasive procedures, the CPA can help to minimize the inconvenience and scope of the exam. Let the professionals handle your income taxes, so you can focus on running your business.

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