How to Avoid an Audit: Common Red Flags

Common Audit Triggers for Small Businesses

Essentially, the IRS selects who to audit by running tax returns through a computer program that flags those that are significantly different from the norm. It also sometimes selects returns to audit based on the taxpayer's relationship to someone else the selection program flagged. Several factors can trigger this program, particularly how you complete tax forms, what credits and deductions you claim, and what your return suggests about your business activities.

Improper Filings

Flag-worthy errors may include:

• Internal inconsistencies

• Inconsistencies with other returns involving the same transactions

• Rounding up, down, or averaging values

• Misreporting or failing to report part of your income

• Consistently filing late

Credits and Deductions

The government offers tax incentives to encourage entrepreneurship. But if you take too many credits or deductions, or take credits or deductions that aren't common in your field, the IRS may flag your return.

Particularly, the IRS may scrutinize the following deductions extra carefully:

• Business losses, especially if claimed in several consecutive years

• Business expenses that appear excessive

• Travel expenses, especially if extensive

• Office expenses when you work from home

• Vehicle expenses, especially if you claim the vehicle is only used for business

• Substantial charitable contributions

By law, you can take business expense deductions only for necessary and ordinary expenses.

Implications About Your Business

Sometimes, how you operate your business raises questions when you file your tax return, like:

• Having many independent contractors, especially if you have few employees

• Operating a cash-based business

• Earning a high income (over $200,000) as a sole proprietor

• Earning money as an S corp shareholder through distributions much higher than your salary

Other circumstances that provide an opportunity to violate regulations may flag your application, as well.

How to Respond to an Audit

If the IRS selects your business for an audit, it notifies you by mail, and you complete the audit by mail or in person, never by phone. The notice should explain what you need to do and the date by which you need to do it.

What Happens During an Audit

The IRS audits businesses and individuals by reviewing their records. Typically, the IRS will audit returns filed within the previous three years, and it will request records no further back than six years unless fraud is suspected. At the end of the audit, the IRS notifies you of its conclusions. Then, the audit ends when the IRS:

• Concludes your return was accurate

• Identifies issues, and you agree

• Identifies issues, and you disagree

When you agree changes are necessary, you need to pay overdue amounts. If you disagree with the IRS, you can:

• Request a conference with an IRS manager

• Attend mediation

• Appeal to a court

• Pay the amount the IRS claims you owe, even if you don't agree with their assessment

If you exhaust your options, the IRS can compel you to pay any overdue amounts.

Responding Efficiently

Read through the IRS notice carefully, then consult your tax advisor. If you need more time, notify the IRS and ask for an extension.

The IRS may ask for copies of:

• Receipts and bills

• Canceled checks

• Lawsuit-related and other legal documents

• Loan contracts

• Logs detailing ongoing costs like travel expenses

• Business-related travel tickets

• Medical and dental records

• Documentation of theft or loss of property

• Documents related to your employment

• Schedule K-1 (a document used to report shareholder information for S corporations)

Locate the documents as soon as possible. Then, organize them by year and type of expense or income and attach a summary of all documents. If the IRS asks for documents you don't have, don't just ignore that part of the request and hope for the best. Speak with your tax advisor about the underlying issues the IRS might be looking for and how you might provide the information they need in another form. The IRS may also ask you to complete a questionnaire. Again, consult your tax advisor as you complete this document.

How to Minimize the Risk of Being Audited

Several strategies can minimize the risk that the IRS will audit you. In particular, you should focus on recordkeeping, obtaining professional advice, and not claiming credits or deductions you may struggle to support.

Keep Thorough, Accurate Records

Many businesses, especially small businesses, keep sparse records, spread out among several locations, and only loosely organized. By not organizing your documents, you risk reporting inaccurate information on your return and being unable to prove what you know is true. You can purchase accounting software to make recordkeeping easier. Most companies offer training on their products, and many even fly reps out to you for such training. Having your records stored electronically makes the entire process more efficient.

Create a paper filing system, too, if you use a lot of paper in your business. You can sort documents by type, customer, business partner, or something else that makes sense to you. Once you have your filing system in place, maintain it. Don't pile documents up thinking you'll get to them later, only to lose track of what's where.

Rely on Tax Professionals

Accountants and tax lawyers cut down the risks of audits immensely. Not only do they help you complete your tax returns, they can review your filings and flag potential audit risks. Then, they can help you address those risks before you file. If you don't have one, consider hiring a full-time accountant. However, you still have options if a full-time accountant doesn't fit into your business plan yet. You can hire a consultant to help you establish a system, arrange for part-time accounting, request help on specific issues only, or work with a specific person to come to another arrangement to obtain the advice of a tax professional.

Err on the Side of Caution

If you have doubts that you could prove you qualify for a deduction or credit, err on the side of caution. Only take deductions if you have documentation to prove them or if a tax professional advises you that taking the deduction or credit is unlikely to raise issues.

Also, be careful with whom you do business. When the IRS audits a business and finds serious issues, it often audits others who work regularly with that business.

Avoiding Audits

Although you can't reduce your audit risk to zero, you can minimize your selection chances by taking affirmative steps and avoiding certain red-flag-raising actions. In short, keeping accurate records, relying on the advice of professionals, and erring on the side of caution should help you avoid being audited.

Disclaimer: Bizee and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.