Audits can be especially frightening for small and medium-sized company owners because they risk owing more taxes on restricted resources or being personally accountable without the assistance of a professional accounting department.
If somehow the IRS is tormenting your dreams, let me put you to sleep: only about one out of every 100 companies is audited every year. Furthermore, there are a few simple things you can do to avoid the IRS's menacing gaze.
As a small-business owner, your probability of being audited increase if you:
-Earn over $1 million annually (this isn't necessarily a bad thing, but if this describes you, it's definitely a good idea to incorporate to protect yourself and your assets).
-You failed to report all of your earnings.
-Claim disproportionate business deductions to your income.
An ounce of prevention is worth a pound of cure, as the saying goes, and we're here to help you avoid the mistakes that lead to an IRS audit in the first place.
Why are audits conducted on small businesses?
In this article, we'll take a glance at six of the main factors small companies get audited, and include pointers on how to avoid becoming one of them.
It's important to note, but even so, that you might be audited for reasons further than your control. The IRS uses random selection to audit some returns, and your return can also be aimed for an audit because of something sketchy that one of your business associates or investors did.
What to do when you receive an IRS audit notice (Source)
For those things you can control, I reached out to our friendly neighbors at the IRS for some helpful hints and resources, and compiled the following list:
6 ways to avoid an IRS audit
1. Stop spending money on entertainment events.
Are you going to take a potential client to a baseball game or a concert to win them over? That's fine, but you'll have to pay for it yourself.
The government eliminated business-related entertainment deductions as part of the Tax Cuts and Jobs Act of 2017. If you try to avoid the system in order to keep your annual customer appreciation night, the IRS will send an auditor your way.
Meals, on the other hand, are still fine, so eat up.
As reported by the IRS:
"Taxpayers may continue to deduct 50 percent of the cost of business meals if the taxpayer (or an employee of the taxpayer) is present and the food or beverages are not considered lavish or extravagant. The meals may be provided to a current or potential business customer, client, consultant or similar business contact. Food and beverages that are provided during entertainment events will not be considered entertainment if purchased separately from the entertainment, if the cost is stated separately from the entertainment on one or more bills, invoices or receipts."
Apart from entertainment costs, here is a useful reference for businesses on popular deductions under 2017 tax law and post-Tax Cuts and Jobs Act tax legislation.
2. Don't go too far with your deductions.
Don't get me wrong: as a hardworking company owner, you should take every possible deduction. But, you should be aware that the IRS employs a computer algorithm (Discriminate Income Function) that analyzes the number and amount of deductions you claim to those of other firms in your income bracket.
Therefore, if the average firm in your tax bracket takes 12 deductions and you take 212, you'll be contacted by a helpful IRS agent to assist you reduce that number.
This is not to say that you should forego lawful deductions for fear of an audit. Indeed, CPA Jeffrey Levine says that one of the most common mistakes he sees small-company owners make is failing to deduct reasonable business costs like a home office for fear of an audit.
It does, however, imply that if you believe you can save money by deducting $500 for placing a $10 piece of plywood over a curb in front of your business and calling it a wheelchair ramp, you should reconsider. Taking hundreds of "miscellaneous" deductions is likewise a bad idea, as the IRS no longer allows them.
According to CPA and QuickBooks expert Hector Garcia, home office deductions, business travel, and car mileage are among the most overused company deductions. So utilize them when necessary, but keep in mind that the IRS is watching.
3. Create a corporation or an LLC.
Small companies are audited more frequently than corporations since incorporation demonstrates a degree of organization and financial expertise on the side of the company.
Apart from the lessened audit risk, there are other compelling reasons to incorporate:
-Personal assets (house, automobiles, money) are often at stake for many small-business owners in order to repay creditors if their company fails.
-Corporations are more likely than small enterprises to obtain bank business loans.
-Corporations can deduct more than small enterprises (such as retirement plans and employee healthcare).
If you were considering incorporating anyhow, you can now add "reduced likelihood of getting audited" to your list of reasons.
4. Be proactive in dealing with irregularities.
Consider the following scenario: your small landscaping firm has made around $80,000 in revenue over the last three years. You got a lucrative new contract with the local government this year, and you bought in three new commercial lawn mowers to handle the added work. Suppose your income triples from the previous year, and you now qualify for more than $10,000 in Section 179 deductions.
There's a fair probability this will raise some red flags at the IRS. So, instead of sending over the figures and hiding under your desk with your fingers in your ears waiting for the inspector to arrive, be proactive.
5. If it is not absolutely essential, do not file an updated return.
When you're racing against the time, it's easy to say to yourself, "I'm fatigued, and I still have to open the store at 6am tomorrow; I'll simply file this for now to meet the deadline, and then file an updated return later to clear up any problems."
It was a bad idea. Submitting an updated return is a clear flag to the IRS that you have no idea what you're doing. According to the Internal Revenue Service:
"Filing an amended return does not affect the selection process of the original return. However, amended returns also go through a screening process and the amended return may be selected for audit."
In other words, while you may have gotten away with an error or two on your original return, your updated return allows the IRS to audit you again, and the revised return itself may be a red flag.
File an updated form if you truly, honestly, messed up and missed to take a legal deduction that will cost you thousands of dollars. But, it is far preferable to spend an extra hour or two getting it correctly the first time.
6. Electronically file
In 2019, this should be the sole option, however according to the IRS, around 10% of individual taxpayers still filed on paper in 2018. I'm sure there are some company owners who still file on paper because they're Luddites or attempting to stick it to the IRS in a hipster fashion. But, you should attach a handwritten letter with those paper forms that reads, "Dear IRS, please have an auditor double check this return."
Why? "The mistake rate for a paper return is 21%," according to e-file, the IRS electronic filing system website, "while e-filed returns yield an error rate of only one half of one percent."
In other words, a paper return is more than 40 times more likely than an electronically submitted return to include mistakes.
Additional benefits of filing online include:
-When you use pen and paper to file your taxes, you are more likely to overlook tax credits and deductions.
-Direct deposit and electronic filing allow you to receive your return in less than three weeks, as opposed to two months for a paper return.
-Most tax preparation software provides audit warnings for actions such as deducting a home office or mixing personal and business mileage.
Additional IRS guidance:
Unlike what Irwin R. Schyster may have taught you, the IRS is not out to attack small companies, and they'd prefer to complete a clean return than make extra effort to collect taxes.
What should you do if you are audited?
We looked at several things you can do as a small-business owner throughout the year to prevent an IRS audit in this post. But what if you're still targeted for an audit?
Don't freak out. This is the moment to be entirely transparent, submit any appropriate documentation, and cooperate cordially with the IRS representative you are dealing with. The IRS has its own advice for making an audit go as smoothly as possible.
And, if you really want to be safe, purchase solid accounting software and utilize it every day to weed out mistakes before they happen, as well as find a trustworthy company accountant to whom you can turn in times of need to keep you on track.
Have you undergone an audit? If yes, what lessons have you learned that you can share with other small-business owners? Share your thoughts in the comments with other business leaders!
