Running a small business is a tedious affair. There are many cash transactions and unplanned expenses. The fear of an audit of your tax return may mount every time you read about the annual tax audit statistics.
Although the overall IRS audit rate has significantly dropped this year, this is not a guarantee that your business is excused from the prying eyes of an auditor. If you have received an audit letter, you may need immediate tax audit help from a professional.
As a small business owner, it is unlikely that you are financially prepared for paying more taxes. Here’s an exhaustive list of expert tips for avoiding the dreaded tax audit altogether.
1. Electronic Filing.
It is advisable to file your return electronically, not just because manual filing is soon going to be defunct. It is highly likely that manual returns have errors, and hence the IRS keeps a definite check on all returns filed in paper. Since about 80% of the taxpayers have already adopted the e-filing system, those who are still ditching the system may not be dealt with an easy hand.
2. Filing amendments.
If you file an amendment, your return is likely to come up in the IRS screening process twice – once for original filing and once for the amended one. Of course, genuine and absolutely necessary amendments can’t be avoided.
3. Reasonable deductions.
One of the surest ways to get the IRS knocking at your door is, claiming huge deductions in the return. Deductions that go overboard and reduce your taxable income significantly will come up for questioning inevitably.
4. Avoid round figures and vague categorizations.
A financial statement with spectacular round figures ending in exact zero digits is a definite red flag. The same goes for accounting heads that read “miscellaneous expenses”. Your financial statement should be exact and specific otherwise they will appear fake or made-up.
5. Get incorporated.
Corporations and LLCs have a lesser chance of getting audited by the IRS as compared to unincorporated businesses. This is because incorporated entities are organized and are expected to be more compliant due to inherent checks and systems under corporate laws.
6. Recurrent business losses.
If your business is filing for losses year after year, the IRS may suspect that the business is not legitimate and just a means for avoiding tax payments. Loss-making entities should be able to establish legitimacy of operations through transaction receipts and records.
7. Home office deductions.
Home-based businesses have the benefit of claiming home office deductions. In the present situation of the Corona pandemic, home office deductions may be viewed under a slightly different light. For instance, your home office should be a dedicated and identifiable space used regularly for business.
8. Schedule-C trap.
Income tax returns that claim deductions under Schedule C are often scrutinized under the IRS audit screening process. You must refrain from using Schedule C just for the sake of reducing your taxable income. Only legitimate expenses should be deducted under Schedule C.
9. 1099 and related Forms.
Property transactions often attract further inquiry and explanations. 1099 and related forms should be duly filled. These can be promptly filed online. Payment of tax liability in this regard should be done in time.
10. High-income proprietorship firms.
In the case of proprietorship firms, an unusually high income is likely to be audited. If you have earned more than a million dollars this year and your business is yet to be incorporated, you would probably be hearing from the IRS auditors.
11. Independent contractors vis-a-vis Employees.
If the IRS is convinced that you are wrongly classifying payroll employees as independent contractors or freelancers, you will get an IRS audit notice for overdue payroll taxes. You may get penalties for avoiding taxes too.
12. Deductions as startup costs.
In the case of startups, there are many heavy costs involved in the first year of business establishment. All expenses cannot be deducted in a single year in which they are incurred. Some costs need to be spread over the following years in the form of depreciation. If you have wrongly claimed an expense as a deduction for the year, instead of depreciating it, you can expect the IRS to contact you for additional tax payments.
13. Deductions for vehicle use.
While claiming vehicle use expense, the IRS allows either a standard rate of deduction or the deduction of the actual expenditure incurred. In either case, you will be required to produce an accurate record of vehicle use if you wish to claim full-time business use of the vehicle.
14. Entertainment deductions.
Many business owners are in the habit of claiming expensive entertainment bills as business development expenditure. It is not OK to claim deductions to a concert ticket as a business expense. The IRS will not allow such extravagance as business-related deductions.
15. Deduction for Donations.
Philanthropic activities and donations on account of businesses are acceptable. You can also claim some tax benefits for such contributions. But if there is any unrealistic or huge charitable donation on your business account, the IRS auditors have a good reason to come looking for some explanations.
16. Reporting all income sources.
Unreported income does not go undetected. The IRS receives tax returns from every individual and business, and can easily narrow down on someone trying to escape taxation. Even barter transactions and auction sales have to be reported with complete disclosures.
17. A Balance between lifestyle and business.
If your lifestyle expenses appear to be too pompous, more than what your business income can support, the IRS can suspect underreporting of income.
18. Cash transactions.
The IRS is always apprehensive of cash transactions and expects to report any such transactions over $10,000. A business receiving most of the income in cash is of special interest to the IRS.
19. Basic financial analysis.
There are some financial analysis ratios which evaluate the reasonableness of a business. There must be consistency in the profits and expenses over the years. Your financial statements should also be consistent with industry performance. Any inconsistency deserves deeper investigation.
20. Professional Assistance.
If you hire the services of a qualified tax professional or accountant, you can avoid the common pitfalls that lead to tax audits. You may benefit from getting the most out of allowed deductions while eliminating blatant errors.
21. Avoid human errors.
Income tax return which is sloppy and has mathematical and human errors, can get shortlisted for IRS audit. Even if you have hired a CPA or accounting professional for assistance, you should check their work for consistency and accuracy before filing.