Running a small business can be very challenging, and that’s without putting taxes into the equation. Even if you do your best, pay and file your taxes time, and report everything the way you should on your tax return, there’s still a chance that you might get audited.
Today, the IRS audits less than 1% of taxpayers and less than 2% of small business owners that make less than $100,000. The tax audit rate increases to 2.3% for those small businesses that earn more than $100,000.
So, while the IRS only audits a small percentage of small business owners, there are still things you may be doing that would increase the chances of getting an audit. Since some audits are inevitable, it’s a good idea to be prepared and fly right. This means filing your annual tax return correctly and maintaining an accurate set of books and documentation. If you do get audited, you’ll need to have the right paperwork.
Unfortunately once an audit has started, there’s nothing you can do to stop it and IRS fees, interest, and penalties can add up. The IRS will work with you if you owe money; there are IRS tax relief programs set up to help taxpayers pay back the money they owe to the IRS.
This article will look at some red flags that can lead to an audit. It will also point out some practical ways to avoid these small business tax audit triggers and the best way to best prepare for an audit if you cannot avoid it.
What Triggers an IRS Business Audit?
There are many ways in which the IRS determines who should be audited. They are able to match up your business records with your submitted tax returns to see if the information is accurate. They also have an automated system that determines which tax returns need to be double-checked.
The IRS uses a computer program called the DIF (Discriminant Inventory Function) system. The system scans tax returns and analyzes them in order to tell the audit committee which tax returns need attention. When a tax return results in a high DIF score, an IRS agent does a formal review to determine if it should be audited or not.
The DIF system catches anomalies, duplicate information, and any tax credits or deductions that do not match up with what the norm is for that type of tax return. When the system raises a red flag, it is the responsibility of the human IRS agent to determine if the tax return actually warrants the extra attention or not.
The UIDIF (Unreported Income DIF) determines which tax returns need to be audited based on the potential of unreported income. Missing income is a preventable red flag that may warrant further attention by the IRS; it usually will eventually result in an audit. Read more aboutwhat is involved in an IRS audit.
The Different Types of IRS Audits
An audit is essentially an investigation by the IRS. There are several ways that an audit is performed by the IRS.
- Office Audit – This type of audit is managed at one of the IRS’s local field offices.
- Correspondence Audit – This is the lowest level of an IRS audit and usually only focuses on simple errors on a tax return; everything with this type of audit is done via mail.
- Field Audit – This is when an IRS agent comes to your place of business, home, or tax professional’s office.
The IRS also performs 7 different types of audits:
- Information Systems
Red Flags that May Result in a Tax Audit
The following 6 small business tax audit triggers may be avoided. Learn about each one to see what you can do to prevent triggering an audit, or at least how you can best be prepared for one if you do inevitably receive an audit.
Audit Trigger #1 – Missing Income
If you are hiding or not reporting some of your income, you may trigger an audit red flag. If you fail to report income on your tax return such as the amounts you received from form 1099, the IRS will know about it. Since the IRS receives a copy of all 1099 forms and W-2 forms, in general, they know what you are supposed to be claiming. Typically you will receive a 1099 form if you earn over $600 from any vendor.
So, if you have a small business as a writing service and fail to claim $700 you received from a client as profit for a job, you may be risking the chance of getting audited, because the IRS will have received a copy of form 1099 from that client; the IRS matches the 1099 forms they receive from both clients and small businesses, so you should always report what’s on your 1099.
As more and more people are working virtually, the IRS has incorporated a way to determine whether you are reporting all of your income or not by working with third-party payment companies like PayPal. Companies like this will notify the IRS if you go over a certain number of transactions or if the total transactions go over a certain amount. The IRS is now able to report the information from PayPal with the amount of income you report on your tax return.
Because the IRS matches your tax return to your paperwork, you should verify that your numbers are correct. The key is to report all income. That’s the best way to prevent an audit.
Audit Trigger #2 – Claiming Business Losses Year After Year
Reporting business losses may be inevitable especially when you’re starting a new business; if you have business losses, you should claim them. The IRS understands new businesses need time to turn a profit. That’s why time is allowed for you to start earning a profit before they begin to wonder why you keep claiming losses.
The IRS will start to take notice if you consistently claim business losses because businesses are supposed to make money. If you continue to claim business losses year after year, the IRS may come to the conclusion that you are taking some tax deductions that you should not be taking, just so you can avoid paying taxes. Business losses lower taxable income thereby reducing tax liability.
The IRS may audit your business venture to see whether it should really be classified as a business or if it is a hobby. According to the IRS, you must earn a profit for your small business 3 out of 5 tax years. If you don’t, the losses are considered to be hobby losses. The rules for hobby losses only allow you to claim losses up to the amount you have profited from the hobby.
If you have legitimate business losses, claim them correctly on your taxes, but keep in mind that businesses that claim losses are more likely to be audited. The reason for this is that the IRS will question why you are staying in business if you have recurring business losses. They may suspect you are making more money than you are reporting or that your business should be classified as a hobby rather than a business.
For more information on the limits the IRS has placed on business losses, check out the IRS information on business loss limitations.
So what do you do if you want to claim business losses? First, take a close look at your deductions and make sure they are allowed under the tax code. Next, make sure all of your documentation is in order in case you do get audited. Lastly, consult with an accountant or tax professional if you are unsure about whether you should claim business deductions or not.
This is a common small business tax audit trigger, so learn the rules. It’s important to have someone familiar with tax laws in the event of an audit. Borshoff Consulting LLC offers audit representation for small businesses, so you are in safe hands if an audit is indeed in your future.
Audit Trigger #3 – Underreporting Income from a Cash Business
The IRS is more likely to take a look at your tax return if you own a cash business. This is because it’s much easier for a cash business to hide or misrepresent income. Cash is just harder to track than checks and/or credit card payments. There are many cash business owners who do underreport their income and therefore owe the government taxes. For this reason, cash businesses a target for audits.
Some examples of cash businesses are car washes, convenience stores, beauty salons, taxi services, and house cleaning services, and they are more likely to be audited since they deal predominately in cash.
If instead of receiving a 1099 form in January, you received $700 cash for haircuts you did, it’s easy to overlook this income since it was all cash. Credit card processors report 1099-k forms to the IRS, showing the total credit card transactions you processed for the tax year; the IRS uses this information in a formula to calculate how much a cash business should have produced during the year. If your estimated income doesn’t line up with theirs, you may face an audit.
The best way to avoid an audit is to make sure you report all cash payments even for small jobs. It shouldn’t matter how you get paid; just make sure you report all of your income. If any of your cash receipts are over $10,000, you will need to file form 8300. You can find form 8300 along with more information about this form and how to file it on the IRS’s website
The key to surviving an audit is to and keep detailed, accurate documentation to support your income claims. Maintain good records of your cash transactions by keeping all cash receipts and write down any cash payments and/or tips that you receive. Proper documentation can make all the difference when you are facing an audit.
You may want to invest in accounting software to track all of the cash transactions that you deal with on a daily basis or hire an accountant or tax professional to help you keep your books in order.
Audit Trigger #4 – Rounding Numbers and Making Mistakes
If you are rounding numbers or making mathematical mistakes on your small business tax return, you are running the risk of getting an audit. Rounding numbers may seem easier to you, but they stand out to an auditor.
The IRS views those types of mistakes as “sloppy.” They think if you are being that careless, what else is wrong with your tax return? This means they will look closer at your tax return.
Making mistakes is one of the preventable small business tax audit triggers. There should be no reason for rounding numbers or making math errors. Most tax returns are prepared via tax software, which alleviates math errors.
Also, if your business records don’t add up with the numbers you report on your tax return, the IRS will notice since they have copies of your business records. If something does not add up, they will look into it and possibly do an audit on your tax return.
One of the most common errors that occur on tax returns is the reporting of incorrect social security numbers or EINs (employer identification numbers). Double-check your work when you are finished. Make sure you have all of your identification numbers correctly entered.
The best way to avoid mistakes is to put all numbers on your tax return precisely as they should be. Account for every penny, and if you cannot figure out where or why you are off, get some help.
If you are truly having trouble reconciling your numbers or filing your small business tax return, hire an accountant or tax professional and let them help you out. It is worth the small fee, because if you get audited, you may owe much more than you expected, and if you don’t have proper documentation for other things you have claimed on your tax return, you will be in trouble when the auditor comes to inspect the details of your tax return. Avoid unfortunate errors by trusting the best to do your taxes for you.
The IRS’s computer system matches the information from W-2 forms and 1099 forms issued to non-employees to the amount of income that’s reported on tax returns using identifying numbers like the employee’s social security number. Discrepancies from this can lead to an IRS tax audit because these computer checks raise red flags for the IRS agents.
Although mistakes happen, it’s important that you triple-check your tax return, because the IRS will hit you with fees, interest, and penalty whether the mistake was intentional or not. If you are unsure of your math and tax preparation skills, use a good tax software program when preparing your taxes, and don’t round any numbers just to save time. The IRS knows what your taxable income was last year – to the penny.
Audit Trigger #5 – Reporting Excessive Business Expenses
Claiming a lot of business expenses is a common audit trigger. Many taxpayers find the line between personal expenses and business expenses to be blurry, so they tend to err on the side of what will provide them with the biggest tax advantage.
Well, if you are claiming expenses that are not truly business-related, you may find anxiety when you get audited. The best way to avoid this is to keep strong documentation of anything you view as a business expense.
Meals and travel related to the business are okay, but entertainment is usually not a business deduction. Keep all receipts so that you can justify any purchases you make that you believe to be business-related.
If you think a business expense is deductible, just make sure you have a strong accounting system to back it up or better yet, work with a CPA, Accountant, and/or a tax professional.
Are you wondering if you should hire someone to do your taxes? Are you confused as to what you can and cannot expense? Read our article to help you decide if you should hire someone to do your taxes.
Audit Trigger #6 – Mixing Business and Personal Expenses
The IRS can be very strict when it comes to blurring the line between business and personal expenses, so it’s important to understand where the line is drawn before you make business deductions on your tax return.
Mixing business and personal expenses may give the IRS a reason to take a closer look at your tax deductions. The IRS uses business codes to measure the normal amounts of deductions based on the industry. A tax return that shows 20% or more than the typical amount of deductions may warrant a second look.
In today’s virtual work-from-home world, many people have home offices and use them for legitimate work. There’s nothing wrong with that, but it is an area that the IRS looks at carefully. There are just too many taxpayers that take advantage of this deduction for the IRS to ignore it. However, the home office deduction rules are very specific and strict, so it’s a good idea to consult a tax professional about this deduction before you try to claim it.
Another audit trigger of mixing business and personal expenses is trying to deduct 100% business use out of your vehicle. Many drivers try to deduct total business usage when really that is a rare occurrence. While some people do use their cars as part of their business, they also use it to run errands like going to the beauty parlor or to pick up their kids from school. This is considered to be personal usage.
If you do have a vehicle that is for 100% business use, keep diligent records. Keep track of all miles in a vehicle log. This can be pretty simple. Just record the dates, miles, and descriptions in a notebook. If you want to, there is also software available for this purpose. Just be sure to record the purpose of every trip. As long as you keep excellent records, you should have nothing to worry about even if the IRS does audit you.
To be eligible for business tax deductions, your purchases must meet two criteria. First, the expense must be required for the conduct of your business; second, the purchase should be appropriate and normal in the trade or industry you work in. By reviewing those two criteria factors you should be able to tell whether an expense is allowable or not. The IRS will take a close look at any expenses that don’t meet both requirements.
Since the IRS does still do tax audits, it’s a good idea to be aware of these small business tax audit triggers so you can understand how to report them correctly or how to avoid them altogether.
Also, by becoming familiar with these audit triggers, you can feel more at ease this year when filing your taxes.
It’s important to understand what you should be claiming or deducting, and what kind of documentation you need to have ready; if you don’t have the right supporting material, don’t claim that you do. Additionally, if you don’t meet the IRS requirements for a business deduction, don’t take it. It’s pretty clear.
Now that you know all about small business tax audit triggers, you should understand how to reduce your chances of getting audited. Check our article for more tips on how to avoid an audit.
Do you know who can help you with every part of your taxes? We specialize in tax returns, financial planning, and more. To see how we can help out with your own returns, contact us today! Borshoff Consulting can help you with one-on-one audit assistance, support, and representation. You can trust Indiana’s Tax Expert!