Before getting too stressed out about the audit, keep in mind that only a tiny fraction of entrepreneurs have to undergo it every year. While the IRS audits only a small percentage of small business owners, there are still things that you can do to make your chances of getting an audit higher.
Small businesses rarely get audited. They usually fail to make enough money to draw the attention of the IRS. In general, only about 1% of the American population is ever audited. Only about 2.5% of small business owners who make less than $100,000 in revenue receive an audit. The likelihood increases as income rises.
The thing is, though, that your chances of getting the IRS to audit your small business taxes are relatively slim.
Since the IRS does indeed audit taxes, it is good to know about these small business tax audit triggers so that you can figure out how to properly file or avoid them entirely. Make sure to accurately report your income and expenses, and to keep your records organized, just in case a large amount of your income really does tip you off to a small business tax audit. As long as you maintain great records, you should not have much to worry about, even if the IRS does audit you.
What to Expect During an Audit
When you are audited in any given tax year, the IRS will compare your tax returns with your actual books to see if any discrepancies exist. The truth is, the triggers of an IRS audit affect only a very small percentage of tax returns, and typically, auditors are satisfied if you submit the paperwork that supports your numbers.
The IRS uses random sampling to audit certain returns, and it is possible your return could even come under an audit for something unscrupulous done by one of your business partners or investors. Sometimes audits are completely random, so even though you did everything correctly, you might still end up on the receiving end of a few letters from the IRS inviting you to explain something about your return.
If your tax returns are not thorough, your numbers are not adding up, and they contain errors, then your company is likely flagged for an audit. Whether it is because of discrepancies in your tax returns or because of an accidental audit, all business owners need to prepare themselves for the possibility of a IRS audit.
The IRS Isn’t THAT Scary
It can be extremely scary for most business owners to imagine the IRS going through their businesss taxes, whether they are in charge or not. Fortunately, while tax audits seem terrifying, there are sound strategies businesses can implement to address tax mistakes and avoid auditing this year.
In this article, we will explore a few things that you can do throughout the year as a small business owner to help you avoid setting off an IRS audit. This article will also highlight some practical ways you can avoid these tax audit triggers for small businesses, as well as how you can better prepare for audits when you cannot avoid them.
The IRS announced at the end of 2020 that they would be increasing small business tax audits by 50% in 2021. At a conference at the American Institute of Certified Public Accountants late last year, DeLon Harris, deputy commissioner for the IRSs Small Business Examiners Division, told attendees to expect to see an uptick of the frequency with which the agency audits small businesses in 2021, to as much as 50 percent.
Audits Are Serious Business
You really need to take small business audits seriously, but the audits are usually about basic data or reporting errors the IRS suspects might have occurred, said Frank Pohl, a shareholder and former lawyer with Gunster Law Firm. If the business for which you are filing all of these deductions looks to the IRS more like a hobby, you may be headed toward auditing — and eventually having to pay back taxes. Deductions that are not proportionate to the revenue from your business are the biggest tax audit triggers.
If you keep filing for business losses year after year, the IRS might conclude you are taking certain tax deductions you should not, just so you can avoid paying taxes. Losses on your Schedule C If you claim losses on your Schedule C, Profits or Losses from Business, year after year, your returns could raise a few flags with the IRS.
If you are filing a Schedule C to report profits or losses from your business, the chances that you will attract extra scrutiny from the IRS increase. If your company has failed to show profits in most recent years, the IRS can come calling to see if you are really running a real business.
Retain Relevant Paperwork in Case You Are Audited
If your company is audited and you are filing losses, be sure you have the paperwork showing the income and expenses for the business for that entire year. If your business is the subject of an audit, as well as the tips mentioned above, prepare yourself to prove the business is eligible for any tax breaks claimed. If you own a small business that operates as a writing service, and fail to report $700 that you received from a customer as a work-related income, you could be at risk for auditing, as the IRS would receive a copy of your Form 1099 from that customer; the IRS matches 1099 forms received by clients and small businesses alike, so you should always report what is in your 1099.
If you are audited, the IRS is going to want to see that you had a legitimate business, and not a hobby. Even if it was a legitimate omission that you forgot to report all of your income, that is not going to be seen as such if you are audited. Certain items on your tax returns, like leaving out money or reporting losses year after year, may get noticed by the IRS and result in an audit.
You have to devote all of your time and attention to the actual running of your business, which is why tax audits can be especially difficult. If you have not reported any substantial business income–$10,000 or more–strongly consider hiring a tax professional to take care of an audit.
You should also know that the IRS uses a computer program (Discrimination Income function) that compares the number and size of your deductions with other businesses in your income bracket. If a standard business in your income bracket takes 12 deductions, but you take 212, then you will be hearing from a friendly IRS agent who can help you cut down on that number. If you take 200 deductions, while the standard business in your industry takes 20, you are probably going to be hearing from the IRS.