How to Avoid a Small Business Audit By The IRS
How to Avoid a Small Business Audit By The IRS
During tax season and throughout the year, IRS agents carefully review every tax return that comes across their desks. However, agents take a second glance if they catch something on a return that seems abnormal. This may result in an IRS audit during which the IRS contacts a taxpayer to clarify certain information.
The IRS audit process varies based on the extent of the information needed, and an audit can be for an individual taxpayer or a business. Taxpayers typically receive an audit notice in the mail to begin the process. Or, an auditor may visit your business in person to examine certain financial records. It can take several months – or even a few years – to fully resolve an audit.
If you’re wondering how to avoid an IRS business audit, use these tips:
1. Adopt a formal entity structure for your business.
If you work as a sole proprietor, the IRS will likely give your tax return some extra attention automatically. So, why not set up a formal LLC or corporate entity? Doing so can give your enterprise more credibility, allowing you to claim deductions and other tax-saving measures without fear that your activities will be examined more closely. Simply registering a formal entity for your venture can help reduce your risk of a small business tax audit.
2. Always file a completed business income tax return.
There are many taxes for small business owners to be aware of and ultimately cover on their IRS returns. After your income tax return has been completely filled out from top to bottom, review it with a keen eye. Be sure that every line that is applicable to your business tax situation is filled out completely and correctly. If you send an incomplete tax return to Uncle Sam, the IRS may question why you failed to disclose certain information on your return. This could trigger an audit.
3. File and pay your personal and business taxes on time.
Following filing requirements is critical when filing both personal and business taxes. If you do not meet all IRS filing deadlines that apply to your situation, you may face late-filing penalties, interest, and perhaps even an audit. Request a filing extension if you know you won’t be able to file by a particular deadline. Also, don’t forget about your additional filing requirements as a business owner, such as quarterly estimated taxes.
4. Report accurate income amounts on your tax return.
Taxpayers in higher income tax brackets – particularly earners of over $200,000 annually – often have a greater chance of being audited. Many small business owners fall into these higher tax brackets. Whether you earn income via a W-2 job, 1099 contract work, a small business, or through interest or investments, remember that all taxable income must be reported on your return. Attempting to hide income could get you in hot water.
5. Be careful about claiming large business deductions.
Entrepreneurs are eligible for a wide array of small business tax deductions. However, if you do not properly claim these write-offs through sufficient receipts and financial documentation, your income tax return could be flagged for an audit. Plus, don’t overstate your business expenses. These tips are particularly important when claiming the home office deduction, the vehicle deduction, and the meals and entertainment deduction on your tax return. Accurate small business bookkeeping can help you track all expenses and, in turn, claim eligible deductions.
6. Claim accurate deductions on business losses you incur.
Business losses are common for any business owner, especially during the startup phase of a new company. To properly write off any business losses your enterprise incurs, they must qualify as deductible losses. The best way to classify your losses as such is to incur them under the umbrella of a formal business entity like an LLC or corporation. If not, the IRS could say you are attempting to deduct personal losses and start an audit of your filings.
On another note, if your business cannot show 3 years of profitability within a 5-year period, it may be audited since your net losses have outweighed any profits in the company’s first 5 years of existence.
7. Pay yourself – and your shareholders – a fair and reasonable salary.
Set fair and reasonable salaries for your specific industry. This applies to paying yourself and paying shareholders and those who work for you. If you overcompensate yourself or your employees, the IRS could take issue with this practice. Also, employee salaries that are overly high are not necessarily tax deductible.
8. Be aware of extra IRS scrutiny on cash businesses.
Do you operate a cash business like a car wash or beauty salon? If so, always fully report the taxable income your business generates through proper small business accounting. Failing to do so could lead to further examination of your business practices through a small business audit. Basic recordkeeping can help you avoid audit risks if you primarily deal in bills and coins.
The bottom line is if you play by the rules and fulfill your requirements as a small business owner, you should not have to be concerned about an audit.
If you need help with your taxes, or other legal advice about your business, LegalZoom can help. Our legal help plans let you speak with a tax professional about your tax issues and independent attorneys for other legal questions.