A tax audit can strike fear and loathing into the hearts of business owners. But, in reality, the Internal Revenue Service (IRS) won’t arbitrarily make your company the subject of an audit investigation. In fact, according to IRS.gov, only 0.6% of individual returns and 0.97% of all corporation returns were audited from 2010 to 2018. However, we know 2020 was a complex year for everyone, and the IRS has said it will increase audits of small businesses by 50%. So, what precautions can your business take to help avoid being targeted this year?
Ensuring your business doesn’t catch unnecessary attention from the government comes down to good habits. Here are a few ways you can minimize the likelihood that you’ll be audited or ensure a more positive experience should you be audited.
Handle audit triggers with care. The IRS has an accrual system when it comes to audit points. If you take deductions or file taxes as an independent contractor, you are at an increased risk for an audit.
- Home office deduction: Employees who work from home are no longer able to take itemized deductions. However, if you are self-employed, you can still claim the home office deduction on your Schedule C. Be sure to follow IRS guidelines when claiming this deduction and be careful if you are claiming larger-than-normal deductions due to the pandemic. Proper documentation is key.
- Charitable deduction: New rules require taxpayers to retain records for donated property with a value of $250 or more. Note that the Coronavirus Aid, Relief, and Economic Security (CARES) Act allows you to take a $300 charitable contribution deduction if you don’t itemize.
- The IRS is cracking down on conservation easement donations, so it’s essential to have all supporting documents and receipts.
- Mileage deduction: This is a hotly contested area within the tax community. Many people take advantage of this deduction but a high percentage abuse the system, making this area a top audit trigger. Leveraging technology can help. You can easily document mileage using GPS history to support your mileage claims.
- 1099 Income: Keep in mind that the IRS gets copies of all 1099s and W-2s you receive and can easily match numbers, so you should be reporting all income for which you receive these forms. If you have more than two clients, the IRS might focus in on your business. The key to ensuring your 1099 income doesn’t trigger an audit is to keep your records both complete and compartmentalized, meaning, don’t intermingle bank accounts.
- Schedule Cs: The IRS will throw up a red flag if a profitable gig worker doesn’t file a Schedule C. If you are self-employed and are making a profit, you should be filing one of these forms. Conversely, the IRS will also discriminate against losses claimed on this form from businesses that are actually considered a hobby.
- Meals and entertainment: Large deductions are targets for the IRS especially if the cost doesn’t match the business’s activities in the IRS’s eyes. Make sure you’re following the recent IRS guidance.
Other deductions to watch out for include:
- 100% use of a business vehicle – The IRS knows this is rare.
- Early withdrawals from IRAs and 401(k)s.
- Alimony deductions – You must satisfy the specific requirements.
- Gambling winnings and losses – Both are red flags to the IRS.
- Day trading losses – You must sell securities frequently and consistently.
Follow best practices. When it comes to filing your small business tax return, several items might cause scrutiny. Here are some ways you can avoid a second glance from an IRS agent:
- Sole proprietors take more heat than LLCs. Registering as an LLC or corporate entity not only gives you more credibility but also reduces your risk for audit and increases tax-saving opportunities.
- Give your tax returns the respect they require. Cross every t, dot every i, check it twice, and file by the due date or extended due date of the return. Be sure to report all the information required – incomplete tax returns, along with unreported income, is a surefire way to invite an audit. If you know you will not be able to file on time, request the extension. It is much better to anticipate the inevitable than incur avoidable attention (and fees!).
- Understand your business losses. Failing to classify business losses correctly could force the IRS’s hand. The best way to file losses is under the umbrella of a formal business entity like an LLC or corporation. In addition, while start-ups often experience fits and starts, if your business cannot show three years of profitability within a five-year window, the IRS will claim your net losses have outweighed your profits and will move to audit.
- Large real estate losses are big targets for the IRS. Agents will check to see if necessary hours are met for landlords who have other day jobs.
If the IRS contacts you about an audit, CPAs advise that you don’t panic. Remember, you are not going on trial, you’re simply being asked to verify some of the claims you made on your tax return. It’s best to remain calm and cooperative when dealing with the IRS.