Avoiding an IRS Audit | How-to Guides for running your business from Business.com

Of all the ways you can be unpleasantly surprised in your business, few measure up to notice of an IRS tax audit. Only about 1 to 2 percent of all returns get audited each year, but that still means a million or more tax filers can expect the IRS to review their returns.

While there's no sure-fire way to keep the IRS at bay, there are strategies you can take to reduce your audit risk. Understanding basic tax rules is important, as is using sound business practices. Where most businesses get into trouble:

Taking improper business deductions
Overstating or understating company officer salaries
Not filing employee payroll tax forms or failing to submit employee payroll taxes
Misclassifying employees as independent contractors
Operating in an industry with a known high rate of tax problems (including restaurants and construction)

Action Steps
The best contacts and resources to help you get it done

Hire a good accountant and heed the advice you get

Finding the right accountant is one of your most important tasks. It's best to hire someone who's familiar with small business, and it's even better to retain an accountant with experience in your specific industry. For example, if you own a restaurant, you'd be wise to find an accountant who's dealt with restaurants and understands the need to collect taxes on employee tips — an issue that trips up many restaurant owners.

I recommend: You can shop for a Certified Public Accountant or verify the standing of one you're considering through the national CPA Directory. You can also try the Directory of Accounting Professionals, which includes CPA's, other accountants and enrolled agents. Also check out these tips on hiring a CPA.

Watch your deductions.

One of the perks of business ownership is the ability to write off expenses and reduce taxes. But be careful. Oversized deductions are a red flag to the IRS and can trigger an audit. Get caught slipping personal expenses into the business mix and you might find yourself not only facing a back-due tax bill but penalties to boot.

I recommend: Brief yourself on the range of small business tax deductions. Also check out the IRS overview of business deductions.

Make sure your contractors aren't employees

The IRS has strict rules governing the use of independent contractors. Misclassified contractors are a favorite target of IRS auditors.And it's easy to slip up because the rules are complex.

I recommend: Use the IRS fact sheet, Employee or Independent Contractor? You should also be aware of special rules governing so-called statutory employees who are sometimes misclassified by businesses as contractors. Read up on statutory employees in the IRS Employer's Supplemental Tax Guide.

Collect, pay and record payroll taxes

If you have employees, it's your responsibility to make all required payroll deductions. The IRS takes this responsibility very seriously and can be harsh on business owners who slip up. The task is especially important for restaurant owners who are required to make deductions for tips.

I recommend: Review and follow the IRS guidelines for employee taxes. Business software like QuickBooks can help automate the payroll deduction process for you. You'll also need to keep records for four years. To find out what records you need to retain, review this checklist of employee records.

Keep good records on all cash transactions

If you're in a business that handles a lot of cash, you can expect the IRS to be suspicious. Cash doesn't leave as distinct a paper trail as other transactions. If you're living the high life but reporting low income from a cash business, don't be surprised if an IRS auditor knocks.

I recommend: Keep thorough records of cash transactions. Use a software system and keep records daily and monthly of all cash transactions. Be sure to report each cash payment over $10,000 as required by law.

Regularly view your anti-audit defenses

At least once a year, check your IRS compliance situation, preferably with your accountant. Tax time is usually most convenient and allows you to make any necessary adjustments before filing.

I recommend: For a quick review, check out What Auditors Look For When Examining a Business and the related Why the Self Employed are Audit Targets.

Tips & Tactics
Helpful advice for making the most of this Guide

IRS rules are complex and honest mistakes are possible. If you make an honest mistake, be sure the IRS auditor understands that. The difference between negligence and fraud is significant: penalties of 20 percent versus 75 percent.
The IRS isn't always right. If you feel you've been wrongly slammed by the IRS, you have the right to appeal.
Learn from your mistakes. Once you've been audited, you'll never want to go through it again. You can't make your business audit proof, but you can dramatically lower the odds of a repeat visit.

The official source of Avoiding an IRS Audit is the Tax Audits page at Business.com

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