Day-to-day operations, employee scheduling, new client acquisition, and more - your business already takes up a lot of your time, and when tax season comes around, the last thing you want to learn is that you’ve been selected for an audit. You must understand how vital detailed accuracy is for your company’s spending and income records, so you can avoid the most common IRS audit flags that cause the IRS to look further into your finances.
What Is an IRS Audit?
You have probably heard of an IRS audit at least once – especially as a small business owner. The IRS has millions of tax filings to process each year, and at times, selects an organization or individual to review and examine financial information in-depth.
The purpose of an IRS audit is to verify that financial information is reported correctly under tax laws and that the reported amount of tax is correct. The IRS will notify you that you’ve been selected for an audit by mail, and it will either be at random or because of a related examination. Your notification will outline why you’ve been selected, the logistics of your appointment, and what documents will be required.
Getting Audited
Upon learning that the IRS will audit your small business, it’s recommended to contact your business lawyer and/or accountant immediately. These individuals are here to help and be an advocate for you through the auditing process. If you haven’t already hired a business lawyer or accountant, you should start inquiring now, so you’re prepared should an audit happen in the future. Aside from the support of a business lawyer or accountant, there are many other details you should consider when going through the auditing process, such as:
- Stay positive. You must maintain a positive attitude when speaking to the IRS agent assigned to your case. Your audit is more likely to go well if you’re courteous and forthcoming.
- Be organized. From the moment you are notified about your audit, you must start organizing all your spending and income records. As a small business owner, this should already be a common practice.
- Transparent and honest determinations. If you keep your spending and income records organized, and have all necessary information laid out for your audit, your accountant and the auditor will be able to provide the IRS with actual determinations regarding your income.
- Pay attention to tax notices. Every notice you receive from the IRS should be documented and should not be ignored. It’s recommended to have a file where you keep tax notices so you’re aware of what’s going on at all times.
The Top IRS Audit Red Flags to Avoid
While it’s unlikely that your small business will get selected for an audit, the possibility still exists. Learning you’ve been chosen for an audit can be worrisome, but maintaining organized income and spending records will go a long way. It’s also recommended to familiarize yourself with helpful audit tips and the common audit red flags that may cause the IRS to take a closer look at your business operations. Read on to learn more.
1. Type of Business
When you’re first starting as a small business owner, it’s not uncommon to remain working full time as your new company gets off the ground. However, the IRS may raise an eyebrow if your income is substantial. It’s not unusual for the IRS to target your small business if you sell health and beauty products or offer house cleaning, landscaping, or construction services.
Because of this, you must create a clear, detailed business plan and stay on top of spending and income records. Regularly reconciling your bank account and documenting daily business activities will save you a headache should you be selected for an audit.
2. Consistently Filing Late
It is your responsibility to file your returns and make tax payments on time. If you’re repeatedly filing late each year, the chances of your small business being selected for an audit increase substantially. Late payments and returns can cause the IRS to think your business is suffering, involved in fraud, or another troublesome scenario.
Setting calendar reminders and scheduling appointments early with your accountant or business lawyer for the upcoming tax season will help you file returns and make tax payments on time.
3. Repeatedly Reporting Losses
Businesses of every size experience losses at one point or another. But did you know that repeatedly reporting losses each year can attract unwanted attention even if it’s true?
Reporting losses often can cause the IRS to label your business as a hobby rather than a valid entrepreneurial enterprise. If your small business is experiencing chronic loss, you must have thorough documentation to back it up as well as proof that your company is legitimate.
4. Claiming Personal Expenses as Business Expenses
More times than not, small business owners list personal expenses as business expenses to recoup the funds. If you decide to claim personal expenses in this manner, you must keep extensive documentation that proves the costs were incurred during business rather than at your own leisure. Personal expenses can include meals, travel, cell phone bills, and more.
5. Too Many Deductions
While claiming too many deductions seems like an obvious issue, it happens much more than you think. It’s a simple way to reduce your income tax bill, but doing so can put you at higher risk for an IRS audit.
All your deductions must be categorized correctly and appear as “ordinary and necessary” for the industry your business falls into. It’s also essential to account for the number of deductions you claim each year because a sudden increase in deduction amount can also be a sign of unwarranted activity.
6. Giving Large Sums to Charity
Many enjoy making donations to help people in need and support important causes, but large donations can raise a red flag with the IRS as a small business. Instead of substantially increasing the amount of money you donate each year, it’s better to maintain a steady level and slowly scale up your charity efforts. Large donations – especially for small businesses – can show up as an attempt to abuse the tax code.
7. Rounded Numbers and Calculation Errors
Mistakes on your tax filings are likely going to attract attention from the IRS, which is why you must make sure your math is correct. It’s not unusual for small businesses to use rounded and average numbers out of convenience.
However, the IRS is more likely to select your business for an audit if exact amounts aren’t used on your tax filings. If you’re hesitant about completing your paperwork correctly, seeking guidance from a tax accountant is beneficial as these individuals are trained and experienced in tax filings.
8. Cash Transactions
Hair stylists, service industry employees, and other fields often take more cash than credit card receipts. If your business is based primarily on cash transactions, the chances of being selected for an audit are much higher as there’s more opportunity for fraud.
At times, the IRS may think that income is being hidden or not being reported in full. Keeping detailed records and proof of every transaction is highly recommended as this will help you prove your income if your cash-run business is selected for an audit.
9. Claiming Vehicle Usage as Entirely Business Related
Like personal expenses being claimed as business expenses, if you list a company vehicle as being used solely for business, the IRS may flag you for an audit. While you can claim a company vehicle on your small business return, it may be easier to avoid it altogether. However, if you choose to do so, keeping thorough records of gas receipts and any other documentation to show that the vehicle is solely for company use is best.
10. Home/Office Expense
Some small businesses don’t use a brick-and-mortar location, so they are run from the business owner’s home. It’s recommended to adequately document the areas of your home that you designate for your business with photographs and precise measurements. Make sure not to include any areas that may be considered personal use space, as this could be an additional red flag.
11. Using Virtual Currency
Virtual currency like BitCoin, Ripple, Ethereum, and more are still relatively new when it comes to business income. However, the IRS has provided strict guidelines on how virtual currency transactions are mandated in a company’s profits. Any use of virtual currency can cause the IRS to perform an audit, which is why it’s essential to avoid centering your entire business around virtual currency.
12. Paying High Salaries to Employees or Shareholders
It’s not uncommon for employees to be listed as shareholders in today’s business structures. However, you must be aware of how their salaries appear to other individuals on your payroll.
If you report paying these individuals higher than average wages, the IRS will likely seek an explanation as it could signify fraud or faulty business ethics. Preparing detailed documentation of everyone’s earned salary is highly recommended, so the process moves along seamlessly if you are chosen for an audit.
Next Steps
Preparing tax filings as a small business owner is already stressful, and even more so with the possibility of an audit looming over you. By keeping the common IRS audit red flags listed above in mind, you can ensure your documents are prepared correctly, so the audit process goes smoothly if you’re selected.
Every audit varies in length depending on the purpose, document organization, and what the IRS has flagged you for. However, being thorough, setting aside ample time for tax document completion, and seeking guidance from an experienced tax accountant will help you avoid being flagged for an IRS tax audit.
If you still have questions regarding IRS audit, we have complied a list of the most common IRS audit FAQs to help you get through the process!
