Tips to Prevent an IRS Audit of Your Small Business
It’s not common for small businesses to be hit with an IRS audit, but that doesn’t mean it’s not possible. When determining if an audit on taxpayers or businesses is necessary, the IRS looks for red flags and patterns. The following tips and avoidable red flags will help reduce your chances of being audited:
File Payroll Taxes On Time
Consistently filing payroll taxes late is a quick way to put a target on your business. If a pattern has arisen, it will raise questions. Ensure you are filing on time to keep your business in the clear.
Report Taxable Income
While being late can cause issues, failing to report payroll taxes is a huge red flag for the IRS and will definitely draw negative attention to your business. Make sure you are also reporting your own personal income. Failing to do so is another warning sign for the IRS. If a small business does fail to report payroll taxes or personal income, they should expect to hear from the IRS.
If your business operates in mostly cash transactions (large and small), there is a greater chance that you will face an IRS audit. This is because it’s harder to verify cash income. If you purchase new equipment or materials for your business with cash, the IRS will most likely have your business on their radar. To avoid an audit, pay for these large purchases with a credit or debit card. If cash is your preferred method for transactions, be sure to keep detailed records for your filings.
Reporting Net Losses in Consecutive Years
Has your business reported net losses for three or more of the past five years? If so, it may raise concern for the IRS. They want to ensure your business is legitimate and not just a hobby, taking advantage of tax deductions. Typically, businesses reporting a profit during that time period are considered legitimate businesses by the IRS. Reporting years of net losses could lead the IRS to believe your business is a possible offender of hobby loss rules. Hobby loss rules could mean your business would lose out on tax deductions. To avoid this, make sure all deductions your business claims are backed with documentation and receipts.
Claiming Excessive Deductions
Tax deductions for small businesses is a great way to reduce your income tax bill. But claiming too many can leave your business at great risk for an audit from the IRS. Choosing tax deductions should be a careful process to ensure the expenses are considered necessary and ordinary for the industry your business is in. Similarly, if a business claims significantly more deductions than in years past, it raises a red flag of suspicion for the IRS. Be as consistent year after year with your deductions as possible.
Large Charitable Donations
Supporting charities is an important way to care for those in local communities. But the IRS often audits businesses that make large charitable donations to ensure they aren’t an attempt to abuse tax code. If your business still wants to donate to charities but also avoid an audit, you must keep donation amounts similar year after year. Slowing increasing the amount each year is a less noticeable red flag for the IRS.
Excessive Vehicle Claims
Car expenses are very common for small business owners. The IRS provides a standard mileage rate for businesses each year. However, if a business claims 100 percent business use of the vehicle, it raises a red flag for the IRS. To ensure an audit is not brought upon your businesses, document all vehicle expenses and also the purpose for your trips, proving legitimate business use of the vehicle.
When deducting expenses for a vehicle, avoid deducting expenses in multiple ways. For example, deductible expenses can be submitted through standard mileage or actual expenses such as fuel and general maintenance. You cannot choose to deduct by both methods in the same year.
Net Operating Loss Carrybacks or Carry-Forwards
A net operating loss (NOL) carryback allows a small business to apply the loss to the previous year’s tax return. A carryforward applies to a tax loss toward a future years’ returns.
While carrybacks and carry-forwards are allowed, they can increase a businesses chance for an IRS audit. The reason for these audits are to ensure legality and that businesses are meeting all agency standards. To prepare for a potential audit, document any carrybacks or carry-forwards.
Watch out for mistakes
The IRS often audits businesses that have simply made mistakes. One big mistake businesses often make is to use rounded numbers. Instead, keep exact numbers (with decimal points) on your tax filings.