As a small business owner, taxes are one of the most important things you need to get right. If you accurately disclose your revenues, losses and the deductions you intend to claim, things may generally go smoothly for you. Fail on any of those fronts, however, and you could cause damage to your business, including liens, closure, and, in some cases, an audit. Though the IRS plans to increase the number of audits it conducts in 2021, the following information could help you avoid that level of IRS scrutiny.
What is a business IRS tax audit?
When you file your business taxes, you are providing the IRS with detailed information about your company's cash flow, which includes the total income, total costs and any deductions or credits you're claiming for the previous tax year. If the IRS believes you made a mistake on your business's return or that you're not being forthright, they will commit resources to make sure everything was accurately reported.
IRS auditors have three years after your tax returns were submitted to call for an audit. Audits are done in one of three ways: by mail, at an IRS office or in person at your business. For every method, an IRS agent will go over your financial records to find any issues in your return, as well as ask you questions about your business's records.
Once the IRS audit is done and a determination is made, you must either address those issues or request an appeal with the IRS Office of Appeals within 30 days.
When are audits conducted?
According to the IRS' website, the agency says it selects an audit subject using a "statistical formula" based on a series of norms from "audits of a statistically valid random sample of returns, as part of the National Research Program the IRS conducts." The agency also uses related examinations, which they select when returns are likely to "involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for audit."
Business tax audits will increase in 2021
Owning and operating a small business in 2020 was fraught with hardships because of the COVID-19 pandemic and the resulting economic strife. With government programs like the Paycheck Protection Program created to help entrepreneurs stay afloat with forgivable federal loans, the tax landscape has changed, which is sure to cause headaches for many entrepreneurs.
As you prepare your 2020 tax return, you should know that the IRS is paying more attention to small business tax returns. During an American Institute of Certified Public Accountants event late last year, De Lon Harris, IRS Deputy Commissioner of Examination for Small Businesses, told attendees to expect how often the agency conducts a small business audit to increase by up to 50% in 2021.
"The IRS is focusing our efforts to increase compliance activity in this area of not only partnerships, but also investor returns related to pass-throughs," he said.
The 50% increase will be based on very low audit numbers in recent years. According to data from the IRS, out of the more than four million partnership returns filed in fiscal year 2018, just 140 were audited, while out of the nearly 4.9 million S-corp returns filed, 397 were audited. The agency estimates it audited "0.60% of individual returns and 0.97% of all corporation returns" between tax years 2010 to 2018.
How to avoid a business tax audit
You can lower your odds of a tax audit by taking certain steps with your tax return and avoiding others – you just need to be "DIF" score savvy. DIF stands for "discriminate information function," a program the IRS uses to determine if your small business-related tax return is ripe for an audit. While DIF details are secret, the steps below can help you reduce your odds of being audited. Each choice you make (how to file, when to file, what deductions to claim) has an impact on your audit odds. Here are 19 things you can do to avoid a business tax audit:
- Be accurate, thorough and neat. Sloppy returns and math errors raise flags. Using tax preparation software makes your return look more professional and helps you avoid mistakes. Accuracy starts with keeping good records; if the IRS ever questions anything on your return, the burden is on you to prove it's right. If your records are sloppy, it will be difficult. Good business accounting software is one of the ways to help keep accurate records.
- Refrain from rounding numbers. Calculating your income and losses with only rounded numbers could make the process easier for you in the moment, but any inconsistencies in the money you're being taxed on will immediately stand out as a red flag for an IRS auditor. Cutting corners here could cause you issues later.
- Explain yourself clearly. Avoid vague business expense categories such as the infamous category some business owners use called "miscellaneous." If your business is claiming unusual deductions of some kind – anything an IRS reviewer might not have come across a thousand times before – provide an explanation or documentation.
- File electronically. Electronic tax return filings are convenient and, in some cases, even required. Electronic filing gives IRS fast access to 100% of your return and in nearly every instance, online tax-filing solutions have ways to check your information for errors. By using the built-in tools, you can ensure that your data is accurate. Many solutions like TurboTax offer an audit protection guarantee in which you will receive representation (or defense services) should an audit be initiated against you.
- Make your estimated tax payments, and issue 1099 and W2 forms on time. Late quarterly estimated payments, nonpayments and underestimated amounts draw the ire of the IRS. Know the deadlines and meet them. File 1099s and W-2s using easy online tax services.
- File on time. It's easy to file for an extension, so there's little reason to miss the initial deadline. Just remember that any money you owe is still due by the original filing deadline; the extra time is for doing the paperwork.
- Beware of your income-to-deduction ratio. Your tax-audit odds for a small business rise if the difference between expenses and income exceeds 52%. Total deductions are only part of it. One especially large deduction can also raise flags, even if others are small or in line with other businesses in your industry.
- Be wary of taking a home-office deduction. Tax returns that include a deduction for a home office are a prime IRS target, so if you plan to take a home office tax deduction, make sure you know the rules. A home office must be a completely separate room or area used exclusively for business. Here again, a CPA can be invaluable in helping you do it right, or perhaps decide if the benefits aren't worth the hassle.
- Make sure you only write off eligible travel and meals. With the passage of the Taxes and Jobs Act of 2017, businesses are only allowed to deduct 50% of their meals and travel expenses conducted for a business.
- Watch those startup cost deductions. Many startup entrepreneurs and new business owners assume that money they've spent to get the business up and running can be deducted immediately. That's not always the case, though; many startup costs must be depreciated over time.
- Don't mix personal and business deductions. The IRS is on the lookout for small business owners who try to deduct travel, entertainment or other costs (cell phones, merchandise, etc.) that are personal and not business-related. Remember that only business-related expenses can be deducted. Make sure you understand the rules on what portion of business entertainment costs are allowable as a deduction. And avoiding taking mileage deductions for personal use of a vehicle – that's another IRS audit hotspot.
- Make your hobby a true business. If the business you are claiming all those deductions for looks more like a hobby to the IRS, you could trigger an audit and end up owing back taxes. A real business has revenues at least some of the time and looks, acts, and spends like a business as well.
- Reconsider your business structure. Owners of a sole proprietorship who file a Schedule C for each business get audited the most. To avoid the higher risk of sole proprietor audits, consider making your business a corporation or limited liability company.
- Hire a CPA or other tax pro. Tax rules that affect small businesses are impossibly complex, far-reaching and downright confusing. Even for relatively straightforward situations, getting professional tax preparation advice can be a huge help in avoiding audit triggers for your particular case or industry. Check online sources to find an accounting firm, tax attorney or CPA in your area.
- Avoid the independent contractor trap. Another favorite IRS is misclassified workers. If your business uses freelancers and other types of independent contractors, make certain they qualify for independent contractor status. Otherwise, the IRS may determine they are employees and stick you with a big bill for back payroll taxes plus penalties.
- Don't "forget" to report income. The one thing the IRS hates above all else is unreported income. And don't kid yourself – the tax agencies are far more sophisticated about tracing money than they've ever been. The IRS has extensive data on typical income levels and deductions for every type of business that exists. If yours is out of line with others like you, an IRS tax audit could ensue.
- Report barter and auction income. The fair market value you receive through business barter transactions may indeed be taxable, even if you did not receive cash. Likewise, taxable income generated from selling items via online auction websites needs to be included in your return.
- Avoid overpaying your shareholders. If your business is run through a group of shareholders, make sure you're not paying those individuals an excessively high wage. That will raise major red flags for an IRS auditor, since that can be seen as an underhanded way to lower taxes by undercutting profits.
- Be honest. Every year, the IRS gets better at using high-tech means to track your business income. Some things are just obvious. If you claim lots of expenses but show little revenue to pay for them, the tax folks get curious.