Small-business owners are deeply involved in daily operations, including customer service, innovation, new client acquisition hiring, and, yes, making money. But tax time throws a wrench into their entire workflow.
Many small-business owners drop everything to put time into completing their tax paperwork because they know how important it is. The idea of an audit is more stressful for small businesses than their larger counterparts. If the IRS comes knocking, you need to provide evidence of earnings and expenditures.
What is an IRS tax audit?
An IRS audit is where the IRS examines a person’s or company’s financial information to make sure their tax reporting falls in line with U.S. tax laws. As part of the process, the IRS verifies:
- Taxable income
A business audit, as the name suggests, is where this process happens at the business level. If the IRS sees tax return errors, they may decide to do a tax audit of that business.
What happens during a small business’s IRS audit?
Tax preparation is hard enough without the stress of an audit. If you get audited, contact your CPA right away. If you don’t have one, you should find a firm that specializes in small business accounting services to help.
Small business audits involve the above nuances but also come in a variety of flavors. Unfortunately, they’re not fun flavors like strawberry or cotton candy. These are:
A correspondence audit is a letter that questions specific items on your return rather than the whole thing. These audits are easy to resolve with receipts or bank statements.
Field audits begin with a meeting with an IRS rep regarding discrepancies in your return. The ball is in your court here, and you choose the time and place for the meeting as well as whether to include your attorney or accountant. You don’t have to provide all of your documentation but should take the time to gather appropriate documentation.
Criminal investigations may be triggered if the IRS believes your small business owes a substantial amount or could be guilty of fraud. In this case, gather all your documentation and consult with an attorney so you understand your case and related tax laws.
As you prepare, be sure to get your records organized, read all tax notices from the IRS, and make clear and honest determinations about your income—all of which are easier to handle with qualified small business accounting services by your side.
What are 11 mistakes you might be making (and how can you fix them)?
If the entire audit process seems like a nightmare scenario, you may be making—or are worried about making—some common mistakes. They’re red flags to the IRS but are easy enough to fix. Here are 11 common mistakes and how to avoid an audit of your small business by fixing them:
1. Multiple Net Losses
If you report net losses in more than two out of the five years of operation, you’ll probably be audited. Sole proprietorships are even more at risk than other small businesses because it’s common to commingle funds.
Pro Tip: If the IRS catches wind of sole proprietorship losses, prepare for an audit. Revisit your income and deductions to make sure they aren’t excessive to avoid this headache. If you claim deductions supported by receipts and documentation, do so cautiously.
2. Filing Late
Aside from penalty fees, late filing can trigger unwanted IRS attention. This could provoke scrutiny that timely filing wouldn’t attract. Overall, it’s best to stay below the radar.
Pro Tip: File your taxes in a timely manner, even if you have to start in January. Don’t wait until the last minute!
3. Disproportionate Salaries
Small-business owners who offer shares of the business to employees have to be careful about salary. High earners who are also shareholders invite interest from the IRS.
But paying employee shareholders isn’t the biggest salary hurdle small businesses face. More commonly, it’s an issue of simply making more money year over year. In 2015, the IRS audited about 1 in 143 people. But as salaries increase, so too will the chances of an audit.
Pro Tip: Get familiar with the average salaries for your line of work so you don’t attract unnecessary scrutiny.
4. Excessive Deductions
You should carefully choose your deductions. Consider whether every meal, travel expense, and stop for gas truly qualifies as a business deduction. Sole proprietors run a greater audit risk, but all small-business owners need to be mindful of their deductions.
Pro Tip: Compare year-over-year deductions and make sure you’re consistent. If it’s your first year in business, choose reliable small business accounting services for help. And remember the golden rule of deductions: The IRS says an expense must be “ordinary and necessary” to qualify as a deduction.
5. Large Charity Donations
Some businesses give money to charity to avoid paying taxes on it, abusing the tax code. If you give large sums of money to charity, this income shift could trigger IRS oversight.
Pro Tip: To avoid getting audited for tax abuse, make reasonable donations year over year regardless of earnings.
6. Business Vehicle Usage
If you claim 100 percent business use of a vehicle, the IRS will scrutinize your return. When you deduct car use as a business expense, choose between the actual expense and the IRS standard mileage rate. If you deduct both, the IRS will be on high alert. Plus, in terms of depreciation and claiming 100 percent business use, you’ll need evidence for every single trip you made throughout the prior year.
Pro Tip: Think carefully about how each vehicle in your business is used, accurately representing the percentage used for your business. This includes mileage, dates, meetings, and so on. A few examples of legitimate business-related activities include:
- Traveling to meet a client
- Conducting research
- Posting mail for your business
- Conducting business-related activity
Unfortunately, your afternoon Starbucks latte run doesn’t count as a deduction!
7. Cash Transactions
If your business deals mostly in cash, you might raise some eyebrows at the IRS because it’s difficult to verify that income. Large cash transactions—such as buying a new company vehicle, investment property, or business equipment—also raise a few red flags.
Pro Tip: Pay for business expenses using a credit or debit card when you can. If cash is your forte, record your transactions very precisely to create your own paper trail. Additionally, any receipts exceeding $10,000 from a single buyer within the U.S. or a U.S. territory in a 12-month period will need an accompanying IRS Form 8300.
8. Calculation Errors
When small businesses handle their own tax returns, it’s easier to use rounded numbers instead of exact ones. But as a result, their math is off, which could attract unwanted IRS attention.
Pro Tip: Never round numbers or use averages. Instead, work in decimal points when you report earnings and expenses for tax purposes.
9. Failure to Report
Failure to report all taxable income is a big no-no in the eagle eyes of the IRS. Small-business owners must report all income made in the U.S., even if it’s held in an offshore bank account, includes cash payments, or falls under other earnings. If the IRS determines that you’re withholding income in your calculations, expect an audit.
Pro Tip: Small-business owners need to stay organized and avoid commingling to prevent mistakes that lead to underreported income.
10. Rental Loss Claims
Claiming rental losses from real estate is tricky because it’s only allowed in certain conditions. If you’re a small-business owner in real estate, claiming a rental loss can draw IRS attention. Get schooled on the right way to handle rental losses by partnering with a seasoned accountant.
Pro Tip: Check out the IRS’ "Tips on Rental Real Estate Income, Deductions, and Recordkeeping" to understand rental losses.
11. Digital Currency
Bitcoin, Dogecoin, Litecoin, and other digital currencies are still relatively new. If you use digital currency in your business, the IRS may perform a deep dive into all your transactions.
Pro Tip: Avoid centering your business around digital currency until we know more about its impact on the national economy and small businesses.
Choose a partner who understands IRS audits for small businesses.
Always follow IRS guidelines for tax deductions—it can prevent your return from being flagged for review! The team at Ignite Spot will work with you to help you understand deductions. Small businesses are our jam, so we’ll find every deduction you’re qualified for.
We can also determine how much your quarterly payments will be each year. Whether you file as an individual or an LLC, we’re here to help you file your tax return. But our support doesn’t stop there. We’ll also lend a hand if your business gets audited by the IRS, ensuring the process is resolved efficiently.
Contact our team today to see how we can meet your small business tax preparation needs.