Any small business owner would go to great measures to avoid a tax audit. Although the possibility of being audited is relatively low, you can’t afford to be ill-prepared. If the IRS does decide to audit you, there is very little you can do to stop it.
Even so, auditing standards and procedures can be confusing, and any tax law changes put into effect each year can make it hard for most companies to stay up-to-date.
Besides, there are misconceptions about which tax forms to use, what dates to file, how much to pay, and whether you’ll owe additional tax or get a tax refund … it can all be frustrating.
In the past, small companies relied on simple bookkeeping or internal accountants to assist in preparing and adjusting journal entries, reconciling accounts, and writing financial statements. But the increase in regulatory requirements has only served to muddy the waters about why one small business is audited and another is not.
An audit committee at the United States IRS office uses a computer program called the Discriminant Function System (DIF) that analyzes returns and red flags them on an auditor’s report if they are outside statistical norms. When a return receives a high DIF score, an agent reviews it to determine if it should undergo an audit — thus, triggering the audit process.
Different types of audits
In general, an audit is an investigation. Audits assure various stakeholders that an area of interest or business activity is free from material misstatement. There are many types of audits, including:
- Compliance audits: Internal auditors review the policies and procedures of an institution (usually educational) or department (within a regulated industry or public company).
- Construction audit: External auditors look at all the costs incurred for a construction project to make sure the costs are fair and justified.
- Financial audit report: A company’s financial statements (balance sheet, income statement, and cash flow statement) are reviewed. It is the most common type of audit and is usually completed by a certified public accountant or an accounting firm
- Information systems audit: Technology is reviewed to ensure authorized users can access certain systems and also that unauthorized users cannot obtain access.
- Investigative audit: Individuals or specific areas are investigated when there is a suspicion of fraudulent activity.
- Operational audit: All the financial information of a business, including the financial position, financial reporting, planning procedures and processes, and operational aspects are analyzed.
- Tax audit: Tax returns submitted by an individual or business are audited.
There are some common triggers that raise red flags on small-business tax returns. If you avoid them on your income tax returns, your odds of a field audit will be greatly reduced.
Let’s take a look at the 8 tax audit triggers you should pay special attention to when filing your small business taxes.
1. Having a higher than average income
It’s interesting to note that the chance of being audited is about the same (about 3%) if you claim no adjusted income or if you make over one million dollars. Earn in excess of five million dollars and the chance of an audit more than doubles. With the increased odds of an audit for those in a higher income bracket, it’s more important than ever to keep meticulous financial records in case you get the call.
If you’re a high wage earner, you may think that by having a tax professional or CPA file your taxes, they’ll be audit-proof. But that’s not always the case. When they advertise that they’ll get you the biggest refund possible, their enthusiasm may cause them to make mistakes, and those errors will cost you in the end. Our professional tax solutions for small businesses will help you stay organized, manage bills and expenses, and ensure mistakes seldom happen.
2. Taking deductions that are disproportionate to your income
Large deductions that reduce the amount of your taxable income may raise a flag with the IRS if they’re out of proportion to your paycheck. When it comes to taking deductions, the IRS uses tables to determine how much is too much for different income brackets — although the tables are not made public.
For example, an IRS agent may come knocking at your door (so to speak) if you claim charitable deductions that are not in line with your income. In addition, a small business that has a low income will sound an alarm if its deductions are larger than normal for that income range.
Sometimes those lopsided deductions are legitimate — such as when first starting a business or during lean years. You should absolutely take the deductions you’re entitled to, but be sure you have detailed records to back them up.
3. Rounding up or averaging income
Rounding up or averaging numbers in everyday life might be acceptable, but when it comes to your tax return, it can trigger an audit. If you made $60,002.36 last year, don’t report your income as $60,000 or you may find yourself sitting in the Internal Revenue Service offices. Why? Because they tend to believe that if you’re sloppy in this area, the rest of your return may not be entirely accurate.
4. Calculating home office deductions
Not long ago, the IRS simplified the home office deduction method. Unfortunately, the requirements necessary to take it have not relaxed. You can still only claim that portion of your home that is exclusively dedicated to your business. For instance, if you use a corner of your bedroom, you can only deduct the square footage of that corner, not of the whole bedroom. And even the corner won’t qualify for the deduction if it’s also for personal use — like if it’s also used as a reading nook or a place where you hang clothes to dry.
Additionally, the amount of your home office deduction must not exceed your gross income after business expenses.
There are two methods to calculate your home office deduction — the simplified method and the regular method. Basically, the simplified method lets you take a standard deduction of $5 per square foot, up to 300 square feet (the deduction can’t exceed $1,500).
With the regular method, there is no limit on the amount of office space used for business, so you determine your deduction by figuring out the percentage of your home used for business. Once you’ve determined the percent of your home used for business, you’ll determine the actual expenses of your home office — including utility costs, mortgage interest, insurance premiums, repairs, and depreciation — and deduct that percentage of these costs.
5. Claiming business losses year after year
The IRS will take notice and may initiate an audit if you claim business losses year after year. They know some people claim hobby expenses as business losses, and under the tax code, that’s illegal.
If you run a legitimate business that continuously reports a loss, the IRS may assume you are taking deductions you’re not entitled to in order to avoid paying taxes. But some business owners do experience a few bad years and can clear up the matter by first proving that their business is legitimate, and then using their records to justify the deductions they take.
6. Filing a Schedule C
Schedule C allows small-business owners to take the deductions that will lower their taxable income. Even so, many people believe that filing a Schedule C increases the chances of an audit. The IRS does scrutinize these types of returns more closely.
But don’t let the fear of an audit keep you from claiming legitimate business deductions. Just make sure that you have accurate documentation to justify all of them. If you don’t want to file a Schedule C, you can set up your business as a separate entity and run all of the business expenses through it.
7. Taking excessive deductions for business meals
Everyone has heard stories of business owners who continually take friends out to eat, pay for the meals, and then write off the expense on their taxes. Unfortunately, the IRS has heard the same stories. If a tax return includes higher-than-average meal expenses, it will set off alarms with the IRS and increase the chances of an audit.
If you’re going to deduct these types of expenses, you must keep records for each write-off. This will include when and where it occurred, who was in attendance, the purpose as it relates to your business, and a record of what was talked about. You’ll also need to keep receipts for expenses greater than $75 when you’re traveling for business.
8. Claiming your vehicle as 100% business use
When deducting your vehicle use for business, you’ll have to choose between the IRS standard mileage rate and actual expenses. Deducting both of these on your tax return will bring the IRS knocking. In addition, if you claim 100% business use on the depreciation form for your vehicle, you’ll need accurate records that include mileage logs, dates, and the purpose of every trip.
You can deduct car expenses in one of two ways:
- Actual vehicle expenses method: When using this method, you start by adding up all of your vehicle operating expenses, which can include interest on your loan (or cost to lease a vehicle), gas, repairs, maintenance, insurance, etc. Next, divide any miles you drive solely for business by the total miles driven. Then, apply that percentage to your operating costs. This becomes your allowable deduction.
- Simplified mileage expenses method: Here, you apply the current IRS-mandated mileage rate to the total miles driven for business in the year. For tax year 2019, the standard mileage deduction is 58 cents per mile of business use.
For either formula, you must keep track of all mileage used for business in a vehicle log. This can be as easy as jotting down miles, dates, and descriptions into a notebook. Or you can use software like QuickBooks Self-Employed to easily track your mileage.
Prepare for an audit even if it may never happen
Every small business needs to be prepared for an audit. The IRS selects who gets audited in one of two ways, random selection and computer screening, and related examinations when other taxpayers are involved, such as investors or business partners.
The two best ways to keep from getting audited is to keep impeccable records and don’t fudge numbers on your tax return. Make sure you report all income, take only proper deductions, and use reliable accounting software or consult with an accountant to ensure all of your income, expenses, and documents are free of errors.