Article written by Milla Liberson, Business Accountant In New York City. (For specific inquiries about your tax problems and options for relief, you can contact Milla directly by email. )
Most small business owners would say there is one thing they try to avoid at all costs, and that’s a tax audit! Many live in fear of the IRS but rather than do this I’d like to educate you on some common situations that could trigger a business tax audit.
Keep in mind that filed tax returns are usually randomly picked for tax review but in addition the IRS uses a computer program which identifies returns that fall outside of the statistical norms. Typically, there are some common situations known to trigger audits and if you attempt to avoid them, you will reduce your odds of being audited.
1. Showing income that is higher than the average
According to statistics, just 0.9 percent of people who make under $200,000 were audited last year, compared to 10.9 percent of those who made over $1 million. If your schedule C shows more than $1 million in sales, the odds of being audited increase substantially. For this reason, maintaining meticulous financial reports is key.
2. Large deductions that look out of proportion to your sales or income
Deduction that reduce your taxable income substantially are a red flag if they seem too high when compared to your income. The IRS uses tables to decide if your deductions are too high for your income bracket. But don’t go searching for these tables because they aren’t made public. We know that at times, those out-of-proportion deductions are legitimate. For instance, when you’re just started your business or during times of slow growth. For this reason, you must keep track of all your deductions and have detailed records if you ever need to substantiate them.
3. Reporting rounded numbers
How likely is it that your investment returns were exactly $1500, or that your mortgage interest deduction was $12,000? Reporting too many round numbers are deemed fishy by the IRS and can trigger an audit. If you made $72,532.65 don’t report $72,500. This kind of reporting is deemed inaccurate and sloppy and if you are found to be inappropriately rounding in one area the IRS will assume you’ve done that in another area of the return. They’ll deem the entire return questionable.
4. Home Office Deductions
Because home office deductions can be so easily abused, last year, the IRS simplified how small business owners can calculate the deduction. But to take this deduction you’ll need to satisfy numerous criteria. This deduction is a big red flag so make sure you’re satisfying every requirement, one such that the home office area be used exclusively for your business.
5. Claiming Business Losses Every Year
Business losses are part of the small business world. The first few years are tough and sometimes you’ll go through a rough period after enjoying profitable years. However, if you are constantly claiming losses, year after year, you’ll be on the IRS’s radar. They might assume you’re taking deductions you’re not entitled to or under-reporting your income.
6. Filing a Schedule C
Most small businesses report their income and expenses on a Schedule C. This form does increase your odds of being audited but don’t let the fear of an audit prevent you from filing this form. One way to avoid filing this form is to have your business setup as a corporation. This can have its own set of issues, but you won’t be needing to file this form anymore.
7. Excessive Entertainment or Charitable Deductions
Some business owners feel entitled to deduct entertainment or deduction expenses and if they are legitimate and fall within the guidelines of the IRS than you should absolutely take those deductions. Taking your family out for dinner or donating to your local religious organization for a purchase of a piece of art is not an allowable deduction. If your tax return has higher than average entertainment or charitable deductions, this will set off an alarm with the IRS and a possible tax audit will follow. For this reason, if you are going to be taking large deductions of the kind listed in this section, make sure you have excellent records. To take the deduction for entertainment you must substantiate where it occurred, with whom, and for what purpose. Deductions of higher than $75 must be accompanied by a receipt.
8. Claiming Your Vehicle As 100 Percent Business Use
Most people get confused when it comes to properly deducting your auto expenses. Basically, there are two ways to do it. The choice is based on which one gives you a higher deduction. You can use the IRS standard mileage deduction or the actual expense. You can’t deduct both. Finally, if you claim 100% deduction of your automobile or you’ll need to have all records on hand. This deduction is scrutinized quite a bit. When deducting for business use of a car, you’ll have to choose between the IRS standard mileage rate and actual expenses. Deducting both on your tax return will bring the IRS knocking. In addition, if you claim 100 percent business use on the depreciation form for your vehicle, you’ll need precise records that include mileage logs, dates, and the purpose of every trip.
9. Drastic fluctuations in income from year to year.
This one is hard because plenty of small businesses have had an unusually good or bad year here and there. If your reported taxable income this year is dramatically higher or lower than in previous years, it might send a red flag to the IRS. Fluctuations in income can signal that something went unreported in prior years. However, if you keep proper records and have a good bookkeeping system, you don’t have to worry. If you can substantiate your expenses and income, you can be ready even if the IRS does have to audit your books.
Need help regarding an audit or looking for ways to mitigate your chances of being audited?
You've been selected for a tax audit and your first reaction is panic! After the realization of this unpleasant news has subsided, now is the time to decide how to handle it. Being selected for an audit doesn't mean you've done anything wrong on your tax returns. Sometimes, the IRS may have picked your return for an examination randomly. At other times, your return was singled out for examination due to some unusual variations in your reported income or expenses which may stand out from the averages based on similar tax returns.
REASONS TAX RETURNS ARE CHOSEN FOR AN AUDIT
When selecting a taxpayer's tax return for an examination, the IRS uses a combination of methods, one of which is a statistical analysis calculated by a massive computer system and programs which compares your tax return figures against other similar returns. Each tax return is coded with a score, which determines the likelihood of your information being accurate. Although the IRS doesn't disclose the formula which figures out a tax return's score, we believe that a number of different algorithms used to figure out the final score. In summary, any tax return whose overall score shows a probability of inaccuracy will most likely be audited.
Under-reported Income - If the computer system determines that a taxpayer's expenses exceed his/her income it may single out the return for an audit. In this scenario the system assumes that the individual or the household has not reported all income to the IRS.
Unmatched income - IRS' computers store massive data, one of which is the required information submitted by third parties. These include income reported on Form 1099's, W2's, Social Security, Retirement distributions, etc. If a taxpayer's income reported on his/her tax return doesn't match what has been provided by third parties, the IRS may follow up with a notice and then an audit.
Incriminating information reported against a taxpayer - If the IRS receives credible information of tax evasion by a taxpayer, it will pursue the lead at full speed. In rare situations the IRS may have the courts enforce legal orders to force the individual who reported the information to disclose all relevant facts to identify participants and their tax evasion schemes.
Audits of related businesses or taxpayers - Some audited tax returns lead to audits of individuals or businesses whose transactions were reported on the tax return of the audited taxpayer. This can include business partners, investors, business clients, vendors, etc.
One audit can lead to another - If the IRS determined wrong doing in your selected tax return, they may expand the audit to include returns from prior years.
Types of Audits
After the IRS selects a tax return for an audit they will notify the taxpayer by letter. There are 3 types of audits:
Correspondence Audit: A correspondence audit is the most common and often the easiest to resolve. Here you just need to provide the IRS requested information to support the flagged items from your tax return. All the communication is done by mail.
Field Audit: With this type of audit the IRS will come onsite to your home, business or tax preparer's office to conduct the examination and review documents. This is when the IRS wants to come to your home, place of business, or your tax professional's office to perform the audit. Field audits are conducted by trained IRS agents who are specialized in discovering tax evasion.
During a field audit you will need to provide requested information, such as bank statements, invoices, bills, etc. This is going to be used to reconcile against the numbers reported on the tax return. Then this information may be compared against a taxpayer's lifestyle in order to determine unreported income or overstated expenses. Because of the invasive and time consuming nature of field audits, it is recommended that you hire a tax professional for assistance and guidance.
Office Audit: This type of an audit is not common and usually involves face to face meeting with the IRS auditor at the IRS office. Office audits are usually reserved, but not limited to, complex issues dealing with itemized deductions or business expenses and income. Handling an office audit is best with a tax professional.
WHAT HAPPENS AFTER AN AUDIT
When the IRS completes its audit, you will be sent Form 4549, which will explain proposed adjustments to your tax return. You can either agree or disagree with the results.
If you agree with the proposed changes you'll need to sign and return a copy of the report, along with a consent form (Form 870) to the IRS. If your adjustment assessed additional taxes, which you can't afford you'll be able to request a payment plan. The payment plan will be based on your ability to pay the agreed upon tax liability on a monthly basis.
If you disagree with the adjustment of your tax liability, you'll be granted 30 day to make your point. Within the time period you'll be able to mail additional information to support your disapproval, request a meeting to review the findings, or request an appeal. If you do not respond to the proposed adjustment within 30 days, the IRS will assume that you are not in agreement with their adjustment, at which time you'll have an additional 30 days to file an appeal. Otherwise, the proposed adjustment will become final and you'll be required to pay the entire amount.
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