The thought of being selected for an audit keeps many business owners up at night. But did you know the Internal Revenue Service (IRS) won’t arbitrarily make your company the subject of an audit investigation? According to IRS.gov, out of the 196 million returns filed in 2016, only 1.1 million (0.5%) came under examination in 2017. In fact, you are statistically more likely to be summoned for jury duty (1 in 10) this year.
Go ahead and let out a sign of relief. Unless you’re operating below the board or completely ignoring best practices, you have little to fear. However, even the most careful tax payers sometimes miss a step. Ensuring your business doesn’t catch unnecessary attention from the IRS comes down to good habits. Below we have listed simple steps you can take to minimize the likelihood that you’ll be audited.
1. Consider what triggers an audit. The IRS follows an accrual point system. For example, if you take deductions or file taxes as an independent contractor, you are at an increased risk for an audit. Below we have listed some of the most common red flags:
- Home office deduction: Under the new tax law, employees who work from home are no longer able to take itemized deductions. However, if you are self-employed, you can still claim the home office deduction on your Schedule C. Be sure to follow IRS guidelines when claiming this deduction.
- Charitable deduction: Lost your receipt for the dresser you donated last spring? You might want to reconsider claiming it as a charitable deduction. New rules require taxpayers to retain records for donated property with a value of $250 or more. For 2019, consider taking pictures of everything you donate to document the condition to prove its condition and value.
- Real Mileage deduction: This is a hot button topic. Many taxpayers take advantage of this deduction but a high percentage abuse the system, making this area a top audit trigger. Thankfully, leveraging technology can help. You can easily document mileage using GPS history to support your mileage claims.
- 1099 Income: If you have more than two clients, the IRS might focus in on your business. The key to ensuring your 1099 income doesn’t trigger an audit is to keep your records both complete and compartmentalized, meaning, don’t intermingle bank accounts.
- Schedule Cs: The IRS will throw up a red flag if a profitable gig worker doesn’t file a Schedule C. If you are self-employed and are making a profit, you should be filing a Schedule C. Conversely, the IRS will also discriminate against losses claimed on a Schedule C from businesses that are actually considered a hobby.
2. Follow best practices. When it comes to filing your small business tax return, several items might cause a closer examination by the IRS.
- The Sole proprietors are at a higher risk compared to LLCs. Registering as an LLC or corporate entity not only gives you more credibility, it also reduces your risk for audit and increases tax saving opportunities.
- Give your tax returns the time and commitment they require. Cross every t and dot every i. In fact, check it twice, and of course, file on time. Also, be sure to report all the information required because incomplete tax returns, along with unreported income, is a fast pass to an audit. If you know you will not be able to file on time, request the extension. It is much better to anticipate the inevitable than incur avoidable attention and penalties.
- Understand your business losses. Failing to classify business losses correctly is another trigger point. The best way to file losses is under the umbrella of a formal business entity like an LLC or corporation. Finally, while start-ups often experience fits and starts, if your business cannot show three years of profitability within a five-year window, the IRS will claim your net losses have outweighed your profits and will move to audit.
If the IRS contacts you about an audit, don’t panic. Remember, you’re simply being asked to verify some of the claims you made on your tax return. It’s best to remain calm and cooperative when dealing with the IRS.
It’s also a good idea to contact your CPA for advice and assistance if you are selected for an audited. He or she can help you understand the process and work with you to try to achieve the best resolution.
Treasury Circular 230 Disclosure
Unless expressly stated otherwise, any federal tax advice contained in this communication is not intended or written to be used, and cannot be used or relied upon, for the purpose of avoiding penalties under the Internal Revenue Code, or for promoting, marketing, or recommending any transaction or matter addressed herein.