Anyone who has endured a business tax audit will tell you that this nerve-wracking experience can test even the most seasoned business owner. Thankfully, the IRS audits less than 2% of businesses each year. If you’re properly documenting and disclosing your finances, you likely don’t have anything to worry about. Still, it’s always better to err on the side of caution. In this blog, we’ll tell you how to potentially handle a business tax audit if you catch the attention of the IRS —and explain how to avoid a business audit in the future.
Why Is the IRS Auditing My Business?
An audit is an investigation, not a legal determination of wrongdoing. Due to an irregularity or another “red flag,” the IRS has decided to review your tax filings and ask for additional supporting information. Here’s a list of some of the most common reasons that the IRS will audit your business.
You Operate a Cash Business
Due to their very nature, cash businesses can raise flags with the IRS. Verifying all income and expenses is difficult for cash-operated business, which helps explain the roughly $500 billion annual tax gap. Be sure to properly document all business transactions, and you should be fine, even in the case of an IRS audit.
You Claim Significant Travel Expenses
Many business owners are required to travel for work, and that’s fine. But once you start blurring the line between business travel and personal travel, like taking vacations to the Caribbean and trying to pass them off as exclusively for business, the IRS is going to notice. The bottom line is that business trips must be for the primary purpose of conducting business.
You Don’t Differentiate Between Entertainment and Meals
Treating clients to sporting events, concerts, and dinners is part and parcel of being a successful small business owner. However, the Tax Cuts and Jobs Act of 2017 eliminated business-related entertainment deductions, so while taking a client to dinner is still fine, you can no longer deduct those tickets to Hamilton as a business expense.
Suppose you take your client to a football game this fall. While you can deduct the cost of their hotdogs and beer, you can no longer claim the cost of the skybox. Instead, you’ll need to itemize your receipts in a way that differentiates what you spent on the meal and the cost of the entertainment.
You Take an “Excessive” Amount of Deductions
Businesses are entitled to take as many deductions as they are legally allowed, but the IRS uses powerful software to compare the number and amount of your deductions with other businesses that are in the same industry and income bracket. Continue to take deductions, but do so wisely, with discretion, a bit of common sense, and educate yourself on appropriate tax laws that apply to your business.
You Haven’t Properly Set Up Your Business
The IRS looks more favorably on businesses that have a clear business plan, intent to profit, and use accepted bookkeeping practices. Notably, if you do not file your personal taxes in Maryland, it’s likely that you’ll face forfeiture of your charter—allowing tax authorities to pierce the corporate veil and seize your business’s assets.
You Filed an Amended Tax Return
Everyone makes mistakes, and filing an amended return is fairly common. But since amended returns go through an additional screening process, the IRS is more likely to flag them for an audit. It’s crucial to file your business taxes early and double-check all of your work to avoid filing an amended return.
You Filed a Paper Return
There’s nothing inherently wrong with filing a physical return. But since the error rate for a paper return is more than 20%, and the error rate for digital returns is less than 1%, the IRS is far more likely to audit a business that files a physical return.
Tips and Techniques for Surviving a Business Audit
Navigating an IRS business tax audit may seem intimidating, but the process can certainly be made less brutal if you have the right information and follow the IRS’s laws, guidelines, and best practices. This isn’t to say that you might not potentially face additional taxes due, fines, interest, or penalties, but the best way to mitigate major problems (and potentially limit the audit from spanning additional years) is to follow these tips and techniques.
Understand Why the IRS Is Auditing Your Business
The IRS performs business audits based on random sampling, computerized screening, and comparative information. If you understand why you’re being audited, you’ll be in a better position to prepare your financial records and be more transparent with the IRS.
Understand the Type of Audit the IRS Is Conducting
Typically, the IRS will audit your business in one of three ways. They will either request further financial information through the mail, ask that you visit a local office, or come to your place of business to perform the audit. If possible, you should push to bring your financial records to a local IRS office or a neutral location other than your business. If the IRS insists on visiting your business, you should consult a tax attorney, CPA, or enrolled agent for assistance. These are the only three practitioners permitted to represent you before the taxing authorities.
Overprepare and Organize Thoroughly
The IRS will want to review all your tax return’s documentation, so organize all of your records in a way that relates directly to your return. Be as neat as possible, and share all relevant and necessary documentation to avoid having the IRS go digging through all of your past records. Here’s some of the documentation you may potentially need to collect during an audit:
- Canceled checks
- Bank statements
- Electronic records
- Financial books, ledgers, and journals
- Appointment books and schedules
- Travel itinerary
- Listed property records (property used for business and personal purposes)
- Vehicle records
- Business meal receipts
File an Appeal Regarding the IRS’ Ruling
Like any other court ruling, you generally have the right to appeal the results of an IRS business tax audit. The IRS Office of Appeals consists of former tax professionals and auditors with legal or accounting experience. Their function is to review the results of the audit and provide unbiased feedback on the initial findings to help resolve any disputes and potentially avoid further litigation. Appealing an audit may result in mitigated or even eliminated taxes and penalties, but the process can be nuanced and complex, which means you should hire a skilled and experienced certified tax resolution specialist before proceeding.
Reach Out to a Tax Professional for Help
Even the most straightforward business tax audit can become complicated quickly, especially if you don’t have the proper financial documentation. If you receive notice that IRS is going to audit your small business, you should reach out to the tax professionals at S.H. Block Tax Services for assistance during this difficult time.
Best Practices to Avoid a Business Audit
To reiterate, most businesses will never face an audit by the IRS. However, you can take simple steps to avoid the possibility of further IRS scrutiny. Here’s how!
Do the Math
Always make sure that the information on your tax return matches your clients’ reporting. Any discrepancy could trigger an audit, so be open, honest, and accurate, follow the appropriate laws, and you’ll be in good shape. Always double check your math and any information you put on your return. If you’re feeling overwhelmed by the sheer volume of documentation, reach out to a certified tax resolution professional for assistance. It’s a lot cheaper and less stressful than having to endure a potential audit.
Keep Good Records
Always keep accurate and meticulous records that are backed up digitally. Keep your business income and expenses in a specific bank account (ideally separate from your personal bank account) and compile all of your receipts. These steps may help you avoid an audit and ensure that you’re prepared in the event the IRS wants to investigate your returns. Whatever you do, never attempt to hide income or inflate your expenses. Lastly, avoid rounding your numbers. The IRS will interpret this as you not being organized enough to provide accurate figures.
Be Mindful of Your Payroll
First, do not inflate shareholder salaries. This could be interpreted as an attempt to minimize profits and avoid tax liability. Secondly, avoid hiring too many independent contractors. In some cases, the IRS might view having an unusually high number of independent contractors as a way to avoid paying payroll taxes. Educate yourself on the rules of employee classification and follow them to the letter.
Maintain a True Home Office
If you work from home and claim a home office on your taxes, be completely honest about the details of the space. As more workers go remote, the IRS is becoming increasingly leery of what constitutes a home office. It must be a separate room that you are using solely to conduct business. If you rent space elsewhere or have a subscription to a co-working space, the IRS might be suspicious if you also claim a home office.
Make Estimated Quarterly Payments
Any business owner who anticipates more than $500 in annual taxes should be paying quarterly estimated taxes to the IRS. Failing to do so can lead to expensive penalties and catch the IRS’ tension. Click here to learn more about estimated quarterly payments.
S.H. Block Tax Services Is Here to Help With Your Business Audit
If you or someone you know is facing a business audit, S.H. Block Tax Services is here to help. In fact, for existing clients, our new software can alert taxpayers before an audit actually happens. This allows you to amend your income prior to the IRS taking action to potentially avoid the time, money, and aggravation involved in a business tax audit.
Please reach out to discuss all of your tax needs by calling (410) 727-6006 today or completing this brief form. And if you’re concerned that you might have filed an inaccurate tax return, we can help you amend your filing, evaluate any outstanding balance, and move on with your personal and professional life.