How to prepare for an IRS business tax audit

The odds of being audited by the IRS are quite low. However, you should still be prepared to support the items you claim on your tax return. You should also understand the issues that can increase the risk of an IRS tax audit.

What triggers an IRS audit?

The IRS can select any business to audit, but there are certain scenarios, particularly among sole proprietorships, that stand out as red flags and draw closer scrutiny. While these triggers may not be avoidable, being aware and prepared is half the battle.

Rest assured that if you consistently follow sound accounting procedure and maintain spotless records, an audit should not yield any serious consequences.

Here are some scenarios that wave red flags at the IRS:

You report above-average income

Higher than average income is obviously a good thing, but it does also make your business more vulnerable to an IRS audit. The IRS knows that high-income returns are both more complicated and more likely to contain errors, and more tax is usually collected from auditing high-income returns.

You run a largely cash-based business

The IRS tends to be very suspicious of businesses that report large or numerous cash transactions. Cash is harder to track and is more easily under-reported than other payment methods—the IRS knows that. If your business involves a lot of cash, make sure to keep excellent records and verify your income.

You claim excessive deductions or business expenses

As a small business owner, you naturally want to lower your tax burden by taking advantage of available deductions. Be aware that if you claim high deductions on Schedule C or report a significant increase in expenses as compared to previous years, you are more likely to face an audit. The IRS has methods for calculating the deductions it deems appropriate based on the nature of your business and your income levels.

While this does not mean that you should avoid claiming deductions that you are entitled to, it does mean that you should exercise proper care in following IRS guidelines and maintaining supporting documentation to prove to the IRS that these are valid business expenses.

The home office, vehicle expenses, business meals, and travel deductions draw extra scrutiny because of the potential for commingling business and personal expenses. Here are some things you can do in advance to protect yourself in case you are ever audited for excessive deductions:

• Save all receipts and supporting documentation
• Claim only deductions that are ordinary and necessary for your business
• Clearly separate business and personal expenses

You report business losses year-over-year

If your business consistently claims a loss, the IRS will want to take a closer look. The IRS understands that businesses exist to make money. If your business reports too many losses, the IRS will examine whether you claimed excessive deductions or if your business is perhaps a hobby subject to hobby loss rules.

You misclassify employees

Because your business saves taxes when hiring independent contractors, if you hire a lot of independent contractors the IRS will want to investigate whether they should be classified as employees instead.

You're under audit. What now?

If you do get the dreaded notification that your business has been selected for an audit here is how you can prepare yourself for the process:

If you do get the dreaded notification that your business has been selected for an audit, here is how you can prepare yourself for the process:

• Review the audit notification and make sure you understand what the IRS is requesting of you. Most audits are not random but focus on a specific issue. Anticipating the auditor's line of questioning will help you provide timely and targeted information which will make the whole process smoother.
• Gather and organize any documentation requested by the auditor. Typically, this will include items such as bank statements, receipts, electronic payment records, and travel logs.
• Consider hiring a CPA or tax attorney to deal with the IRS on your behalf. A professional can interface with the auditor for you and better understand what the auditor is looking for. However, if you have excellent records and a thorough understanding of your business accounting, a professional is not necessarily warranted.

While an audit is nerve-wracking, the key is preparedness. If you consistently maintain proper records and follow sound accounting practices, you should be able walk away from an audit with no negative impact to your bottom line.