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Updated: March 27th, 2020
If there’s one thing that’s sure to get every small business owner’s heart pumping, it’s a piece of mail from the IRS. Maybe you accidentally paid too much and you’re getting a check back? It’s possible, but it’s more likely a request for more information or to review your books. In other words, an audit.
Audits aren’t always a reason for concern, but even a straightforward audit could be a time-consuming nuisance, so it’s best to avoid it altogether if you can.
Before diving into the different ways small business owners can lower their chances of getting audited, it may be helpful to understand how and why an audit can occur.
There are actually four types of IRS audits:
Aside from the random TCMP audits, audits usually occur when the IRS suspects something might be incorrect in a tax return. However, it’s not as if someone is closely reviewing your tax return.
“The IRS simply doesn’t have the manpower or budget to have a revenue agent manually look over every single tax return,” says Logan Allec, a CPA and owner of the personal finance blog Money Done Right. “The IRS uses a proprietary computer program called the Discriminant Inventory Function System (DIF).”
The DIF system assigns each tax return a score based on what’s being claimed in the return. If your tax return has a high score, an IRS revenue agent might take a closer look. Additionally, you could be audited if your records don’t match the records that the IRS received. For example, if another business claims it paid you money that you didn’t report as income.
Overall, for the 2016 tax year, only 0.5 percent of tax returns were audited, and most of those (about 70 percent) were correspondence audits.
Certain things may increase your tax return’s DIF score (and, subsequently, the chance that you get audited). If one of these situations matches your own, don’t feel pressured to change your return and skip deductions. Claim all the deductions you’re entitled to — just remember to keep records of everything.
Many business owners use their personal vehicle for business purposes. Perhaps you’re traveling to different clients, job sites, or offices. “You can certainly deduct your vehicle expenses as a legitimate tax write-off,” says Allec.
However, the IRS also asks whether you have another vehicle for personal use and may be suspicious if you claim you only have one vehicle and use it for business most of the time. Of course, that could be the truth.
“If you’re being honest, you have nothing to worry about,” says Allec. However, if your claim triggers an audit, you’ll need to have evidence to back up your mileage deduction. “It is absolutely essential that you keep a mileage log to prove the miles you drove during the year.”
S corporation business owners who are also employed by their business must pay themselves a reasonable salary for their work as an employee. They can then take the remainder of the company’s profits as an owner’s distribution, which isn’t subject to FICA taxes.
“One of the most common audit triggers for S corporations is a too-low salary amount,” says Allec. “The problem is that many S corporation owners set their salary at a certain amount years ago when they first started their business, but as their business grew, they didn’t update their salary amount.”
To ensure you have a reasonable salary, you may want to check Glassdoor or Salary.com to see how much someone in a similar position at a different company could earn. You don’t need to do this every year, but if your business has grown for a few years in a row, it may be time to give yourself a raise.
It’s reasonable for a business to experience a period of rapid growth or a rough patch. But sometimes, a big change might flag an audit. For example, if your business expenses suddenly double or triple without an increase in your revenue, that might be a red flag. “It just looks funny,” says Allec, “especially from the standpoint of an IRS computer that is programmed to flag anomalies.”
You’re allowed to deduct your business’ expenses from your revenue, but you can’t deduct any personal expenses. Before you file your tax return, make sure you’re not misclassifying an expense.
Some common areas of confusion include:
“It’s imperative for you to double check not only the expenses you’re claiming on your tax return but also the top line,” says Allec.
The IRS should get copies of the tax forms you receive, including 1099-MISC and other income-related forms. These get tied to your business, and if you don’t include these forms (and the corresponding income) when filing your return, that could be a red flag.
Perhaps you did everything right and still got audited. Don’t worry, it happens.
Allec shares the next four steps you should take if you receive a correspondence audit:
“Talk to a tax professional for anything beyond a correspondence audit,” says Allec. “Unless you’ve been through an audit before, it’s probably best that you get a professional in your corner to help you out.”
Funding Circle believes informed consumers are better consumers. We strive to provide informative and educational content useful for you and your business. However, please note that tax laws and regulations are complex and subject to change. We strongly recommend consulting your financial or tax professional regarding your specific circumstances.