Few things will send a colder chill down the spine of a small-business owner than an IRS business tax audit notice. Such notices cause panic, fear, doubt, and anxiety until the audit is concluded.
The good news is that business tax audits don’t have to be scary. This article will explain what you can expect from an IRS audit and how to prepare for it. Although never fun, understanding how auditors think and what they see as red flags during an audit can help make them as painless as possible.
There are many common misconceptions about tax audits. Let’s take a closer look at some of the most commonly asked questions.
What is a Tax Audit?
A tax audit is a review and examination of tax records submitted by a business, organization, or individual. It is designed to confirm the amount of tax reported on submitted returns is accurate. The auditor examines the financial accounts and records of the company to verify the information is being presented accurately and in accordance with the U.S, tax laws.
What is a Corporate Tax Audit?
In general, a corporate tax audit is no different from a business or individual audit. The goal of an audit does not change whether the business is a sole-proprietorship or if the business operates through a different legal structure, such as a partnership or limited liability company.
The only distinction is when a business operates as a C corporation. When it can raise additional money through a stock offering. When the stock is initially issued, there are no income tax implications for either the shareholders or the corporation. In audits of closely held corporations, auditors will look to see if the stock offering is legitimate or being used to disguise taxable income.
In such audits, auditors will look to make sure the price paid for the stock is fair market value and not overly discounted. If family members are involved, their income statements will be scrutinized to ensure that salaries are appropriate for the work completed.
What are the Different Types of Tax Audits?
There are two types of IRS audits: correspondence and field audits. Field audits are carried out either at an IRS office or at the business or home of the taxpayer. Taxpayers are notified by mail or telephone, but not by email. If contact is made by telephone, the IRS will follow up with a letter.
How long does it take to perform an audit?
The time it takes to complete an audit will depend on several variables, such as:
- The type of audit
- The number of records to be reviewed
- The complexity of the audit
- The availability of the requested records
- The availability of all parties related to the audit
- And the taxpayer’s level of agreement or disagreement with the audit’s findings.
Why Does a Tax Audit Occur?
Submitted tax returns are compared to those of similar taxpayers, based on a randomly selected statistically valid sample of audited returns. When a return is selected for an audit, it undergoes an initial review by an auditor, at which point it may be accepted as filed or, based on the auditor’s assessment and experience, flagged due to questionable items. In such cases, the auditor notates the flagged items, after which the return is assigned to an examining group.
A manager then reviews the initial auditor’s work and may accept the return as filed or assign it to another auditor. The second auditor can also accept the return as submitted or schedule an appointment with the taxpayer.
What Triggers an Audit?
While there are any number of reasons why a return can be flagged for an audit, there are some common indicators that auditors look for, including:
The higher your income, the more likely your business is to be audited. In 2015 only 0.7 percent of people making less than $200,000 were audited. Among those making more than $1 million, 9.6 percent were audited.
When your deductions seem out of sync with your income, it triggers a red flag. The IRS has tables that represent normal ranges of expected deductions based on income brackets. If a small business has low income but a high rate of business deductions, there may be questions. However, the IRS also recognizes that in the first few years of operation, a business may have a disproportionate level of deductions.
There are very specific guidelines about what you can deduct for your home office. For example, the space needs to be used exclusively for the business, so be careful about deducting the square footage of your “office” if it’s also the kids’ playroom.
Be accurate and use the IRS guidelines for rounding. If you earn, $75,022 in income, do not report it as $75,000 on your return. If you are inaccurate in this area of your return, there is likely to be more suspicion on other areas.
A Schedule C is the form that’s used by businesses to deduct business expenses, thereby lowering their taxable income. The IRS is 10 times more likely to audit a taxpayer who files a Schedule C. This should not deter you from filing the Schedule C. Just make sure you have the documentation to justify each deduction.
Excessive deductions for business expenses can raise eyebrows. Higher-than-average entertainment deductions is a classic IRS red flag, so be sure to keep accurate records and refrain from writing off that family vacation to Disney as a business expense.
Every business can have some lean years. But if your business is constantly operating at a loss, and your tax returns claim business losses year after year, you could become an audit target. Some taxpayers end up deducting expenses for what is actually a hobby, not a business, which is illegal.
How To Avoid Audits?
The best tips for avoiding a tax audit are related to the scenarios described above. In addition, here are some ways to audit-proof your small business.
- Keep Good Records. Keeping your business expenses and income managed out of a separate business bank account is prudent. Keep all receipts related to business expenses. Make sure you can justify all business entertainment expenses and deductions.
- Check the Math. If you receive a 1099 Form, make sure you report it accurately. The IRS will receive a copy of that form. If your return is prepared by a third party, have them walk you through the calculations and how the calculations relate to the records you’ve provided.
- Pay Estimated Taxes. If you expect to owe more than $500 in taxes, be sure to file quarterly tax payments. Failure to do so can result in penalties and increased audit risk.
- Don’t Use Contractors as Employees. Some businesses use independent contractors to skirt payroll taxes. The IRS has clear guidelines on how workers can be classified; be sure to follow those guidelines and seek advice if unsure.
What Do I Do if I’m Audited?
First and foremost, remain calm. Just because the IRS is auditing you doesn’t mean you have done anything wrong. Here are some ways to approach an audit to be prepared and ready for the examination.
- Decide if you want representation by a third party, either a tax attorney or an accountant. If there is any chance the IRS may think you are trying to evade taxes, hire a tax attorney or a tax relief company with tax lawyers on staff.
- Respond promptly to all IRS correspondence, including letters, phone calls or requests for information and scheduling.
- Let the auditor know as soon as possible if there are any requested records you cannot provide right away. Understand that if your records are electronic, the auditor may ask for them in that format.
- Find an on-site location that is private and away from customers and employees, in which to conduct the audit.
- If the audit’s findings result in penalties or back taxes, understand that you can appeal or negotiate a payment plan. Also, remember auditors can share audit records with other local, state, and federal agencies.
Where Can I Get Help?
If the IRS is auditing your business, you need professional help. Do some research before choosing a firm. Hire a tax relief company that has tax attorneys on staff. Ask to talk with a tax professional and find out what your options are. The tax relief companies below provide a free consultation with no strings attached.
Andrew is the Content Director for SuperMoney, a Certified Financial Planner®, and a Certified Personal Finance Counselor. He loves to geek out on financial data and translate it into actionable insights everyone can understand. His work is often cited by major publications and institutions, such as Forbes, U.S. News, Fox Business, SFGate, Realtor, Deloitte, and Business Insider.