How to Avoid Being Targeted for an Audit

Tax audit. These two simple words are enough to strike fear and loathing into the hearts of many business owners. But, in reality, the Internal Revenue Service (IRS) won’t arbitrarily make your company the subject of an audit investigation. In fact, according to IRS.gov, out of the 196 million returns filed in 2016, only 1.1 million (0.5%) came under examination in 2017.  You are more likely to be summoned for jury duty (1 in 10) this year. Now isn’t that a lovely thought?

Unless you’re operating below the board or completely ignoring best practices, you have little to fear. However, even the most prudent sometimes miss a step. From managing the filing cabinet to the people who hold the keys, ensuring your business doesn’t catch unnecessary attention from the government comes down to good habits. Here are a few ways you can minimize the likelihood that you’ll be audited or ensure a more positive experience should you be audited.

1. Handle audit triggers with care. The IRS considers certain deductions as possible “audit points”.   They also look closer at taxpayers treated as independent contractors.  Below is a list of what could be considered “triggers”.

  • Home office deduction: Under the new tax law, employees who work from home are no longer able to take the itemized deduction for home office expenses, because all deductions in that category have been eliminated.  However, if you are self-employed, you can still claim the home office deduction on your Schedule C. Be sure to follow IRS guidelines when claiming this deduction.
  • Charitable deduction: Lost your receipt for the dresser you donated last spring? You might want to reconsider claiming it as a charitable deduction. New rules require taxpayers to retain records for donated property with a value of $250 or more. For 2019, consider taking pictures of everything you donate to document the condition to prove its condition and value.  If the value is over $250, you need a receipt or letter from the charity.
  • Mileage deduction: This is a hotly contested area within the tax community. Many people take advantage of this deduction but a high percentage abuse the system, making this area a top audit trigger. Thankfully, leveraging technology can help. You can easily document mileage using GPS history to support your mileage claims.
  • 1099 Income: Depending on your type of business, if you have more than two clients paying you, the IRS might focus in on your business. The key to ensuring your 1099 income doesn’t trigger an audit is to keep your records both complete and compartmentalized, meaning, don’t intermingle bank accounts. 
  • Schedule Cs: The IRS will throw up a red flag if a profitable business doesn’t file a Schedule C. If you are self-employed and are making a profit, you should be filing a Schedule C. Conversely, the IRS will also discriminate against losses claimed on a Schedule C from businesses that are actually considered a hobby.  This goes hand in hand with the 1099 “trigger” above.  If you have 1099 income, report it on a Schedule C unless it clearly belongs elsewhere.

2. Follow best practices. When it comes to filing your small business tax return, several items might cause scrutiny. Here are some ways you can avoid a second glance from an IRS agent:

  • Sole proprietors may take more heat than LLCs. Registering as an LLC or corporate entity not only gives you more credibility, it also reduces your risk for audit.  In some instances, you may even have better tax planning opportunities depending on how you are organized to do business.
  • Give your tax returns the respect they require. Cross every t, dot every i, check it twice, and file on time. Be sure to report all the information required – incomplete tax returns, along with unreported income, is a surefire way to invite an audit. If you know you will not be able to file on time, request the extension. It is much better to anticipate the inevitable than incur avoidable attention (and fees!).
  • Understand your business losses. Failing to classify business losses correctly could force the IRS’s hand. The best way to file losses is under the umbrella of a formal business entity like an LLC or corporation. In addition, while start-ups often experience fits and starts, if your business cannot show three years of profitability within a five-year window, the IRS may assert your business is a hobby.  You need to be prepared with a business plan, to support your long term profit motive.

If the IRS contacts you about an audit, don’t panic. Remember, you are not going on trial, you’re simply being asked to verify some of the claims you made on your tax return. It’s best to remain calm and cooperate when dealing with the IRS.

 It’s also a good idea to contact your local CPA for advice and assistance in case you are audited. He or she can help you understand the process and work with you to try to achieve the best resolution.