A small business audit can make any owner nervous. But you can keep your cool if you know what’s coming. This complete guide will walk you through how to prepare and survive a small business tax audit.
Do you know what to expect from a small business audit? There are many reasons you may need to go through an audit as a business owner, and, in every case, it can be stressful. You need to know what to expect if your company is being audited so you can prepare for everything that will be required of you.
Read on to learn everything you need to know about small business audits, what to have on hand if you’re selected for one, and how to avoid business audits in the future.
What Is a Small Business Audit?
A small business audit is an examination of all the important financial statements, tax returns, and accounting books of your business. The goal is to ensure your company is compliant with applicable tax laws and verify that the taxes you reported are correct.
The Internal Revenue Service (IRS) or an external auditor may perform the audit, but businesses often audit themselves, as well.
What Kind of Businesses Get Audited More?
Self-employed: Those who are self-employed face a higher than average chance of an audit. This is due to the IRS putting special attention on making sure that business and personal deductions are not mixed up or used improperly.
Cash businesses: If you operate a cash-based or cash-intensive business, you’ll face additional scrutiny from the IRS. The agency will often want extremely extensive documentation of how much cash came into the business and how that cash was spent.
In the top red flags for business audits, cash transactions come in right after significant business losses related to questionable expenses. This means that any convenience store, restaurant, liquor store or parking garage doing a significant portion of sales in cash, should expect IRS scrutiny.
The IRS has a formula that calculates the amount expected amount of cash sales based on credit-card transactions. The Service is checking this behind the scenes and if/when out of line with estimates, it could prompt an audit notice.
Choice of business entity: The IRS has noticed a trend – audits of LLCs, S-Corps and other business entities favored by small businesses tend to have a good return on investment and effort.
As such, those who utilize these types of business entities should prepare for the possibility of a visit from an IRS officer or a letter from the IRS if there are filing issues, or if you haven’t filed.
Types of Audits
You may immediately think of IRS audits, but that’s not the only kind of business audit. Here are all the types of audits your small business may encounter.
Types of IRS Audits
The IRS may audit a business if they identify a problem with its small business taxes. A business selected for an audit will be notified by mail only, not telephone. There are several ways the IRS may perform the audit, including:
Mail Audits
Office Audits
Field Audits
IRS audits don’t happen very often, but it’s best to be prepared for the possibility at all times. Keep your financial records in order and have an audit trail that proves where your numbers come from. Always make sure you’re compliant with all relevant tax laws for the best result.
External Audits
External audits are performed by a third party, such as an insurance company or local tax agency. This independent auditor will evaluate your business in an unbiased way, usually for legal reasons.
You may get an external audit as a requirement by an organization such as the U.S. Securities Exchange Commission (SEC) or Office of Management and Budget (OMB). The auditor will go through the steps to analyze your financial records and then create a report of what they find.
Internal Audits
An internal audit is performed by you or someone who works for your company. These usually aren’t done for any legal requirement. They are for your purposes, such as examining business operations and management to prevent financial mistakes or to check in on company goals.
An annual audit can help examine your current processes and ensure you’re remaining compliant with laws and regulations. It may also be used to inform investors and shareholders about current company performance.
Common IRS Red Flags
There is no guarantee that avoiding audit red flags will prevent you from getting audited. IRS audits can sometimes be random, so you never know for sure if you will or won’t get selected for one. But eliminating as many of these red flags as possible will help keep you out of the IRS’s sites.
Here are the top seven things that may lead to a small business audit:
1. Errors
Simple mistakes on your tax return, such as being off one number on your EIN or making an error subtracting expenses from business income, can trigger an audit.
2. High Income
The IRS may be suspicious if you report a particularly high income that isn’t consistent with your business’s usual earnings.
3. Exorbitant Expenses
Claiming a lot of expenses, especially travel and meal expenses, can be a red flag. Remember to always keep your expense receipts.
4. Home Office
Home office deduction rules are strict. Speak with a qualified tax attorney before claiming it as a tax deduction.
5. Schedule C Losses – Deductions
Every year, the IRS tends to compare earnings or income against the amount of those deductions and determine if the ratio makes sense. Maybe to an outsider the ratio doesn’t make sense.
If you know that the numbers are correct and reasonable, have the paperwork to back it up and share the details with your trusted audit defense attorney.
Reporting losses on your Schedule C, Profit or Loss from Business, every year can be a red flag to the IRS. If you haven’t earned a profit from your business in at least three of the last five years, the IRS considers it a hobby.
6. Missing Income
Don’t forget to report income from a client. The IRS may become suspicious since they compare the amount reported on your return with 1099s or W-2s they receive.
7. Underpayment
The IRS could audit you If you didn’t pay enough taxes and don’t offer an explanation. Include Form 9465 with your return to request to pay on an installment plan if you can’t pay the taxes owed by the due date.
8. Your Business Keeps Losing Money Year over Year
If you report that your business has lost money for a few or more years in a row, the IRS might wonder why someone would continue such a “business” if it is losing money. IRS suspicion might kick in and lead them to suspect you could be shielding them from money owed by falsifying numbers.
The most important thing to remember is that you should avoid placing anything suspicious in your tax return. If your financial information seems unusual, you may attract unwanted attention.
What Happens During an IRS Audit?
This is a basic outline of what happens if you’re audited by the IRS.
1. The IRS Will Make Contact
You’ll receive a notice in the mail that lists contact information, the next steps, and any documentation they want to see.
2. Follow the Instructions
Get organized and get ready for your audit as soon as you receive the notice. Assemble any necessary financial information and reach out to your accountant for help.
3. Check-In With the Auditor
You’ll need to meet with an auditor in person or reply with your information by mail.
4. Outcomes
The auditor will follow up after the audit to let you know the outcome. The auditor may not find any issues. If they did notice problems with your financial documents, you’ll have the opportunity to either agree or dispute it.
If you agree, you’ll be asked to sign the examination report or a similar form. If you disagree, you can request a conference with an IRS manager, take up mediation, or file an appeal if there’s enough time.
These steps are what you can typically expect to happen when getting audited by the IRS, but there are other possibilities. It’s a good idea to talk through what you can expect with a tax professional.
How to Prepare for a Small Business Audit
It’s important to get your records organized and ready for an audit. Here are five things you should do to make sure you’re ready.
1. Keep Great Track of Your Finances
The main thing you can do to be prepared for an audit is keep your finances organized in the first place. It’s much harder to get your business organized after it’s been a mess for a long time. Unfortunately, hindsight is 20/20.
Do everything you can to get your financial records organized if you know an audit is coming up. Make sure your documents are as complete as possible, too. You’ll need financial records, income information, deductions, and more at the ready and with all the proof you have available.
2. Keep It Neat
Do not dump a box of unorganized receipts in front of an auditor and tell him or her to go through them. A pile of messy records means more digging for the IRS agent, which means more things to find and ask you about.
The auditor may even give you the benefit of the doubt if your records are in order and small issues arise. Tidiness and order appeal to accountants, and most auditors are accountants.
3. Anticipate Auditor Questions
The audit will be easier if you can anticipate what the IRS wants to see. You may get a hint of the problem in the audit notice depending on the documents they request and other information they provide.
If you don’t know what the problem is, take a second look at your tax return to see if you made any errors. Make sure you have documentation to clarify any mistakes or omissions you find.
4. Ensure Professionalism
Nothing will be worse for your case with an IRS auditor than to treat them with hostility and visibly show that you don’t want them around. Be courteous to any IRS auditors you speak with.
Be sure that the presentation of your documents, business premises, and staff is as professional as possible, too.
5. Be Able to Back Up Income Sources or Expense Deductions
You’ll have to be able to show your right to take tax deductions or other tax benefits you claimed on your return. Research tax law or consult a tax expert, if necessary.
Thoroughly review the tax returns being audited before meeting with an auditor or mailing your documents. You never know what items the IRS may request to review, so be prepared.
What to Bring to a Small Business Audit
You need to document your expenses for the audit. Proof should be in writing, but sometimes oral explanations are allowed. The IRS will provide you with a written request for the documents they would like to see, which may include:
- Receipts
- Bills
- Canceled Checks
- Legal Papers
- Loan Agreements
- Logs or Diaries
- Tickets
- Medical and Dental Records
- Theft or Loss Documents
- Employment Documents
- Schedule K-1
The auditor will ask for documents that support the income, credits, or deductions you claimed on your return. Since you used those documents to prepare your return, you should still have them and won’t need to create anything new.
Best Ways to Avoid a Small Business Audit in the Future
You have enough on your plate running your business day-to-day. Here are seven tips for avoiding a time-wasting audit in the future.
1. Check Your Math and Numbers
The IRS expects the numbers on your tax return to match forms they’ve received from third parties, such as a 1099 for reported income. Make sure your math adds up on your self-reported returns, as well.
2. Don’t Report Losses Every Year
Net losses for more than two out of five years may cause the IRS to declare your business a hobby.
3. Keep Meticulous Records and Accurately Report Income and Expenses
Keep all of your business income and expenses in a business bank account and keep your expense receipts.
4. Don’t Pay Very High Salaries to Shareholder Employees
Paying your executives an exaggerated salary can be a red flag that you’re trying to pay lower taxes by minimizing corporate profits.
5. Don’t Hire Too Many Independent Contractors
The IRS has specific rules on who can be an independent contractor because they can be a way to avoid paying payroll taxes.
6. Only Claim Your Home Office if the Deduction Is Legitimate
Your home office must be a separate room used exclusively for business. If you have large expenses for maintenance and utilities or also rent office space, these are red flags to the IRS.
7. Keep Up with your Estimated Small Business Taxes
Whatever amount you expect to owe at the end of the year, you should be making quarterly estimated tax payments.
You shouldn’t fear an audit if you keep good records and are honest on your tax return. It’s always a good idea to consult a tax professional if you’re unsure of the income you should report and the deductions you can take.
What to Do If You’re Facing a Small Business Audit
It’s easy to get overwhelmed when you’re trying to prepare for a small business audit. Use the information we’ve shared here to make sure that the process goes as smoothly as possible.
Are you facing an IRS tax audit for your small business? Contact Silver Tax Group to speak with one of our experienced tax attorneys to get the advice and IRS audit defense you need to protect your business.
