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10 Small Business Tips to Avoid an IRS Tax Audit
As serious as taxes are, it’s critical that small business owners take proactive steps to reduce their risks of being audited.
First, the good news: the odds of undergoing an IRS tax audit has gone down as budget cuts have hit the Internal Revenue Service, resulting in staff cuts. If you’re a small business owner, you still face dramatically increased chances of being audited compared to a regular wage-earning taxpayer. The consequences of an audit can be dire for a business’ bottom line and solvency, even when they are simple mistakes or oversights.
For small businesses like LLCs and partnerships, back due taxes and fines can be directly applied to the individual taxpayer owner. Even when organized as a corporation, repaying the IRS can take a large chunk of a company’s cash flow, making it almost impossible for many to stay in business. As serious as taxes are (and as complex as they can become), it’s critical that small business owners take proactive steps to reduce their risks of being audited, make the results of a potential audit more favorable, and ensure greater financial responsibility of the business overall.
The Chances of Being Audited Are Low
One of the most important things to consider is that the chance that you will be audited by the IRS is slim. According to the 2019 IRS Data Book (which has data for taxes filed in the 2018 tax year), the agency audited less than 1 million total tax returns in 2018 (about 0.15% of individual returns, and about 0.06% of corporate returns). In fact, U.S. businesses being audited hit a 10 year low in 2019. Here’s a breakdown of the returns that were audited:
Individuals with no business or farm income, and no Earned Income Tax Credit, had the lowest risk of audit, of about 0.1 percent.
Only 0.1 percent of S-Corporation tax returns were audited.
About 0.01 percent of partnership returns (Form 1065) were audited.
Individuals with under $25,000 in income faced a 0.28% risk. (Higher risk because of EITC)
Individuals with total income of $1 million or more faced a 0.5 percent audit risk
About 1 percent of taxpayers reporting business income on a Schedule C were audited.
Corporate income tax returns with revenues of up to $1,000,000 increased audit chances up to 0.9 percent.
Corporate returns with income up to $5,000,000 had only a 0.11 percent chance of audit.
Large corporations were most likely to be audited, at 3 percent.
Of all of those audits, however, 73.7 percent were “correspondence audits;” they were requests mailed to the taxpayer to provide additional information or to correct information that may have been miscalculated, and may not have required adverse action. The other 26.3 percent were field audits, the kind some Americans have nightmares about where the IRS and taxpayer meet to go over actual tax records.
Here are 10 ways to lower your audit risk and be prepared for one if it should occur:
1. Keep Good Records & Data
The importance of keeping good records should be pretty clear. Proper documentation of business expenses, mileage logs, and receipts not only helps in the event of a request for information, keeping that data accurate can also help avoid an audit in the first place. Incorrect tax information that conflicts with data the IRS may receive from a separate related source, such as a contractor or payee, can trigger an information audit.
Certain types of tax activity can also gain more attention from the IRS than others- particularly deductions and credits. This is because the initial stage of tax return scrutiny is performed by the agency’s computers, which look for basic math errors, inconsistencies in reporting, and “red flag” items like having significantly higher business expenses, losses or charitable donations than other similar taxpayers. Items that increase a taxpayer’s risk the most include home office tax deduction, business mileage, and other business expenses that are far higher than a business with comparable income.
2. File Your Returns On Time
Taxpayers who file late (or refuse to file) and don’t file an income tax extension draw greater attention to their return. Missing deadlines can lead to back taxes being owed, interest, fines and even criminal action. For small business owners who file a 1040 Schedule C and are unable to complete their returns by April 15 (or simply choose not to), an automatic 6-month extension can be received easily. However, you have to file the request before April 15. Keep in mind that any taxes owed are due by that date as well.
3. Follow the Home Office Rules
The home office deduction is one of the most often abused deductions, after the EITC and other business expenses. With millions more Americans working from home in 2020 and 2021, many taxpayers might be tempted to use the home office deduction. But most will not qualify. The home office deduction can draw more attention from the IRS, especially if the taxpayer is claiming a disproportionate amount of their home as their office, has odd or large expenses, or are attempting to claim a room as an office that also serves another purpose. To be considered a home office and meet the IRS definition to receive the deductible, there are several factors that must be met:
Exclusive use for business. While many taxpayers may find it hard to believe, the IRS expects the area you claim is being used for business purposes, to be used ONLY for business purposes. Not as a den during off-work hours; Not as a guest bedroom; Not as a man-cave; Not as a nursery. It can, however, be used for another home office-based business, with the deduction apportioned between the two. A desk in the corner of another room doesn’t count, either.
Primary business location or regular meetings with clients. You can’t just claim it because you catch up on emails or do a little spreadsheet work there. It must be the primary location for the management of the business, or be where you regularly meet with customers.
Special rules. There are some special considerations for day cares, adult care, and business storage when it comes to deductions.
There are two methods of claiming the home office deduction: the traditional way, which is based on a percentage of the house being used; and a simplified method, wherein the taxpayer can receive a deduction of $5 per square foot up to 300 square feet.
Taxpayers claiming the home office deduction have a higher rate of audit, so it is important to keep good records, notes regarding client meetings on expenses, and honest records pertaining to the business use of that portion of the home.
4. Be Honest
The IRS doesn’t have the means to know everything about your business, including the exact amount of cash transactions you conduct or other details that some might be tempted to ‘fudge’ the numbers on. However, many of the details the IRS reviews are verifiable, such as records submitted by other taxpayers or business entities. When recipient and payee copies of forms don’t match up on tax returns for the two entities, a correspondence audit is very likely. For those who have been honest on their returns, an audit will be an inconvenient formality, but nothing to sweat. For those who have been a little less than forthcoming with their deductions, expenses and income, the time to sweat will be just beginning.
5. Keep Your Records Organized
If the IRS flags your income tax return for an audit (whether a business entity return or an individual return with business income Sch. C or Farm), it can go back as far as six years, if there are substantial or intentional errors or fraud. Even in simple cases of transposing numbers or entering erroneous information, the agency can ask for three years worth of taxpayer data. That means that you should do what you can to minimize your chances for an audit by keeping accurate records and reporting information correctly. You should also keep those documents organized in such a way that you can present them if you receive an information request from the IRS or are subject to a field audit.
6. Is It a Business, or a Hobby?
According to the IRS “Hobby Loss Rule,” a business must be engaged in an activity for the purpose of generating a profit. It’s okay for a business to have losses in some years, but the Tax Court has generally found that businesses that continually result in a loss year-over-year are not actually business entities. Doing so will increase your chances for an audit. In other words, you don’t have a reasonable expectation of making a profit from your activity, you can’t deduct expenses in excess of income. Furthermore, expenses can only be itemized as miscellaneous deductions when they are in excess of 2 percent of the taxpayer’s adjusted gross income. To avoid the Hobby Loss Rule, the taxpayer may consider organizing the business as a corporation.
7. Should You Have Employees or Contractors?
While some types of businesses have to rely heavily on contractors, the IRS can flag a business that uses a higher ratio of independent contractors instead of regular employees when compared to similar businesses in their industry. This is because the business may be doing so in order to reduce or avoid payroll taxes. There are specific rules on which activities should be considered work for employees and which should be for contractors. Not following them can lead to an audit, as well as previous taxes and penalties being reassessed.
8. Pay Your Estimated Taxes
The IRS requires wage-earners and contractors who owed more than $1000 in taxes at the time of their filing to pay estimated taxes starting the next year. Corporations must do so if they expect to owe $500 or more. Self-employed individuals should pay special attention to this section, even those working in the gig-economy like on-demand drivers. This is because those companies treat the drivers and other service providers as contractors and don’t withhold income taxes or pay the employer share of Social Security and Medicare. With those amounts not withheld and paid by an employer, it falls to the business owner or gig-worker to pay for them instead. The estimated taxes are based on the income and taxes expected to be owed for the next year, broken down into quarterly payments. Failure to make estimated tax payments can result in fines and can increase a business’ chances at an audit.
9. Pay Appropriate Salaries
Corporations have a fiduciary responsibility to their shareholders, even if there are only a handful of principals. This includes not overpaying executives, which can reduce corporate profits and is seen by the IRS as a way to lower corporate taxes . As such, overpaying executives can result in an audit. Corporate leaders should be paid a reasonable salary range for the industry and position and be prepared to justify the salaries if necessary. The shareholders will still reap the benefits of the profit of the corporation, but will have to wait until after taxes.
10. Use a Professional Accountant and Tax Professional
Keeping proper books on your business activity throughout the year is the best way to be prepared for taxes reporting requirements at the end of the year. By proactively managing the finances on an ongoing basis, the business and individual taxpayer are in much better position to take advantage of available tax credits and deductions. Likewise, using a tax professional to aid in filing your returns is added assurance that you have complied with your requirements. Meeting with your tax professional mid-year can also result in a more strategic approach that can minimize tax obligations.