Small businesses are often a go-to target for the IRS. According to The Wall Street Journal, small business is in IRS sights as “thousands of small-business owners have received letters from the Internal Revenue Service questioning whether they are underreporting their business income, a harbinger of a broader initiative aimed at boosting federal tax receipts and ensuring compliance.”
Additionally, “Small business owners are up to 940% more likely to be audited than W-2 wage-earners,” according to TaxReceipts.com. “Business owners who are sole proprietors or single-member LLCs face a much higher risk of being audited than the average wage-earner. The IRS has targeted these taxpayers for increased scrutiny as it attempts to close the tax gap and reduce the federal deficit.”
While avoiding a tax audit isn’t clear cut, here are six precautionary measures that can substantially lower your company’s changes of being audited.
Excessive tax deductions.
IRS auditors first look at cash businesses – restaurants, salons, any business where under reporting of tips is common. From there, they move on to sole proprietorships, and small businesses that take a lot of deductions.
Small businesses take a number of deductions that can be hard to justify without rock solid paperwork and receipts (i.e. the infamous home office deduction). This isn’t meant to keep you from taking deductions, but if you do, it’s important to have your ducks in a row when it comes to accurate paperwork and record keeping.
Business returns that are flagged for audit standout given they, typically, don’t fit neatly within a peer group of returns. For example, if your small business reports $40,000 in earnings and you took $20,000 in deductions — it will set off red flags. The deductions could be legitimate, but the IRS is going to want to take a look at the paperwork.
So, ensure to include explanations, photo copies of receipts or additional forms can also help the IRS agent who will take a manual look through your return if your return is flagged in the system.
Business entity preference.
If you manage an LLC, for example, you can often fly under the radar. Forming your small business as an LLC or corporation can take some of the heat off, as deductions for those entities are different and often greater.
Large expenses and losses.
Other areas to consider are expenses and losses that the IRS often looks for in audit-sensitive returns – these can be bad debts, or medical expenses – really any kind of major loss is going to require a paper trail.
Incomplete tax returns.
Incomplete tax returns can also raise a red flag because IRS agents are going to want to know if those omissions were deliberate. Remember, ignorance of the law is not an excuse, but the IRS is more likely to settle with individuals who just made an honest mistake and are willing to cooperate. In some cases these settlements can be reached without a full audit.
Late and amended returns.
Another way to avoid an audit is to file a complete return the first time even if this means requesting an extension. Amended returns are going to be subject to greater scrutiny even though you’re within your legal rights to amend returns for up to three years. Think of it this way: auditors are going to wonder what was missed the first time and why, especially if it results in an additional refund to you.
Estimated ’round’ figures.
Along with this these tips, you should avoid entering all round numbers on your return. It looks like you’re estimating business figures and it makes agents wonder what your records really look like.
The core goal is to avoid big flags and stay neatly in your peer group. If you have a more complex return, you’ll want to work with a professional tax preparer and ensure that you have very good documentation.
Accountants will often tell you to double and triple check your figures, as some of the most common mistakes are data entry errors like transposing numbers or getting off by one field. Doing this will call your return into question even if you did nothing wrong.
The overall probability of getting audited is low, but remember, this probability increases exponentially when you make common mistakes or stand out amongst the average filer. You can never truly avoid an audit, but you can be careful. The most important thing to be sure of is that if you are audited, you have all the paperwork you need to support your initial return.
Bailey McCann is a writer for Funding Gates, the accounts receivable software for small businesses that allows them to track, organize and manage open invoices all with simple clicks. Bailey enjoys writing on business, finance and technology. She regularly covers topics of interest to entrepreneurs, investors and fund managers.
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