The word audit can strike fear into a person’s heart. But the truth is, the IRS only audits a VERY small number of tax returns, and usually it’s satisfied by providing the documentation to back up your figures. This is why organizing and holding on to your relevant records and statements is so important, as we noted in the first part of this Tax Series. Last year, the IRS flagged just under 1% of returns for further scrutiny, and half of those belonged to people making over $1,000,000.
While most of us have earnings that fall well below a million per year, there are still some red flags that are more likely to trigger an audit, especially for small business owners.
Top 10 IRS Audit Triggers
1. Make a lot of money.
As we said, 50% of the returns audited belonged to taxpayers earning more than a million dollars a year. If you make less than a million annually, it cuts your odds of being audited in half. (Although we’d all probably be willing to chance it, right?!)
2. Run a cash-heavy business.
If your business typically deals with a lot of cash, you’re more likely to be audited. The IRS has found a tendency among cash-business owners to “forget” to declare some cash income that might otherwise be reported, and targets these businesses more aggressively. Convenience stores, restaurants, laundromats, car washes, and beauty salons are all more likely to be audited.
3. File a return with math errors.
Errors in addition or subtraction will likely get caught, flagging your return for an audit, even if the mistake is in the favor of the IRS. Since tax software does all of your calculations for you, it has the distinct benefit of protecting you from this particular red flag.
4. File a schedule C.
Many business owners will have to file a Schedule C to report business income as part of their individual tax returns. This is true of sole proprietorships, which make up the bulk of small businesses. Schedule C will show the profit or loss of your company, but also land your return in the more-likely-to-get-audited pile. Frankly, there’s nothing you can do about this other than making sure you have the proper documentation for all your claims.
5. Take the home office deduction.
As described in part three of our Tax Series, Small Business Tax Deductions, if you regularly work at home in an area exclusively dedicated to your business, you are allowed to deduct some of the cost of that space from your income tax. The IRS may challenge you on this, but if it’s legit and will save you enough money, you may decide it’s worth it.
6. Lose money consistently.
Some people try to write off what they spend on hobbies as if they’re claiming expenses as deductions for legitimate businesses. If your company doesn’t show a profit for a majority of the last few years, the IRS may call you in to determine whether you’re actually running a true business venture.
7. Don’t file or file incomplete returns.
Even businesses that show a loss instead of a profit have to file tax returns. Drop off the face of the earth with the IRS for a couple of years, and when you show up again, the tax man will likely invite you in to explain things. Filing incomplete returns can have the same effect, even if all you’re missing is a signature.
8. Have a big change in income or expenses.
If you showed a profit of $300,000 last year but just $100,000 this year, the IRS may be curious as to what happened. Likewise, you could be audited if you show a huge increase from year to year. That doesn’t mean you shouldn’t make as much as you can, just be prepared to document it, as always, along with the expenses you’re claiming.
9. Mix business and personal expenses.
Whether you’re claiming travel, entertainment, or any other kind of expense, you must justify a true business purpose for these deductions. Make sure that your expenses make sense in proportion to your business income. Keep your receipts and indicate the business purpose each expense is for. Don’t take deductions for personal gifts or household items.
10. Use your car for business.
This is another area some people take advantage of, so the IRS tends to look carefully. Except for the costs of commuting, small business owners are entitled to claim business-related auto expenses on their taxes. But as with travel and entertainment, keep proper records such as mileage logs and calendar entries that include the business purpose, as taking this deduction may increase your chance of being audited.
What to do if Audited
Sometimes audits are totally random, so even though you’ve done everything right, you may still find yourself on the receiving end of some mail from the IRS “inviting” you to explain something on your return.
First off, don’t panic. Second, always respond to IRS requests in a timely manner, and always be cooperative and polite. The agency has an information-packed web page that can help you prepare. Third, you may want to consult with a tax professional if you’re audited, especially if there’s a large sum of money involved.
Many times, resolving the situation will be as easy as providing documentation to back up the figures on your return. Often, these audits will take place entirely by mail, and even if you owe additional money, there may not be any penalties involved. However, if you don’t think you’ll be ready in time to meet the deadline, get in touch with the auditor to let them know. You may be able to dispose of some of the questions and get a postponement for the rest.
The IRS has a three-year statute of limitations for tax returns, although in some cases, that can be extended to six, so hold onto your records for that long so you can prove the claims you made. Most audits happen two to three years after a return is filed.
Keep in mind that state revenue departments can (and do) audit tax returns, as well, and in many cases, have a tougher reputation than the federal government does.