To say that 2020 was a difficult year for small businesses is an understatement. The rise of the pandemic caused a steady increase of closures across all industries, which have put many small businesses in survival mode. In the midst of all this turmoil, the IRS Deputy Commissioner for Small Business Examinations made an announcement that did nothing to quell concerns.
During a speech about small business audits, De Lon Harris said, “The IRS is focusing our efforts to increase compliance activity in this area of not only partnerships but also investor returns related to pass-throughs. For 2021 we are planning for 50% more than we had in the previous year.”
For 2021 we are planning for 50% more than we had in the previous year.” — Lon Harris, IRS Deputy Comissioner for Small Business Examinations
Even in a regular year, tax audits are a nightmare for small businesses. Of course, nobody likes audits, but business audits can take months longer than an individual tax audit and stretch even further the resources of already overwhelmed businesses. This is on top of the general uncertainty about the future many businesses are facing. To avoid getting caught off guard, it helps to understand what this increase in audits means for you and your business. You may even be able to decrease your chances of getting audited.
What to expect
While most people do not end up getting audited, small businesses have a higher risk. This is because greater revenues and assets translate into more complex filings. The IRS has no clear-cut definition of small businesses, so it’s difficult to parse out the exact number of audits, but they far outweigh audits for individuals.
One reason to breathe easier is that the IRS performed audits at incredibly low numbers across the board in recent years. In 2018, the IRS audited less than 0.00004% of the more than 4 million partnership returns. In comparison, over 15,000 partnership tax filings were audited in 2010 – 0.48% of the total.
Auditing from the 2019 fiscal year jumped up to 0.2% for both partnership and S-corporation returns. Despite this, a 50% increase in audits for 2021 would still not match the numbers from 2010. The increase would be more about leveling off extreme lows.
Who gets audited?
The IRS only audits a small portion of businesses every year. So, what exactly do they look out for when they make their selections? There are a few clues that they have their eye on. Nothing is a guarantee, but paying attention to these areas will lower your risk.
- Educate yourself: Tax law is complex and has recently undergone some big changes. The most recent development is the Bipartisan Budget Act of 2018. Stay up-to-date on the changes and how it affects the way you file your taxes. The smartest way to avoid an audit is to do everything by the book.
- Stay organized: As we mentioned before, having a complicated income is one reason small businesses tend to be the targets of audits. When you keep pristine and open records of your figures, that bodes well for you. Businesses with messy records that don’t match up will send a warning signal to auditors.
- Consider using tax preparation software to make your life easier. You can share your records with your CPA and, more importantly, you won’t leave figures off by accident. Simple mistakes are a common way to find yourself in an audit.
- Be conscious of your hiring practices: A business can lower its taxes by hiring mostly independent contractors. So can C-corporations that pay their executives a large salary. The IRS is wary about people manipulating the system, so behaviors like these raise a question mark for them. Keep this in mind when making these kinds of decisions.
- Mind your deductibles: Deductibles are another area that can save you in taxes but also send a red flag to the IRS. If you start taking strange deductibles, chances are the IRS will notice and come knocking.
- Make estimated tax payments: Depending on how much you owe in taxes, you may have to make estimated tax payments throughout the year. The IRS expects businesses that owe more than $500 in taxes to make these quarterly payments, so not paying them is a definite warning sign.
Frequently asked questions
How likely is it for a small business to get audited in 2020?
There’s no sugarcoating it: the probability of getting audited for 2020 tax returns is much greater than it was for 2018 or 2019. The percentage of audits will likely increase from 0.2% to 0.4% of the total number of returns. But it will still not match the number of audits from 2010.
Why would the IRS audit a small business?
The IRS functions on limited resources, so it focuses on the small businesses that are more likely to be underreporting taxes. Most of its attention is on businesses with mistakes in their returns or filings that appear suspicious. For example, sole proprietors that claim large entertainment deductions or itemize business expenses are more likely to get audited. Having a good understanding of what the IRS is looking for can help you avoid an audit.
How many small businesses get audited?
The IRS does not keep clear numbers on small businesses for their statistics. Instead, they label returns by business structure. For 2019, the audits for common small business structures like partnerships and S-corporations were just over 17,500. That’s out of more than 9,000,000 returns. If the total returns remain the same this year, there will be about 35,000 audits.
What are the chances of being audited in 2020?
Depending on your business structure, the chances of an audit could be anywhere from 0.4% to 1.2% of the total filings this year.
Ultimately, the odds you will be audited by the IRS are low, but it is certainly not impossible. No statement has come out yet on how this audit increase will progress over the next few years. What we do know for sure is that the chances of getting audited this year are far greater than a year ago. Keeping your house in order now can save you a lot of headaches down the road.