Who's Afraid of the Big Bad Wolf: How to Avoid an IRS Audit

Business.com / Finances / Last Modified: February 22, 2017

Having a qualified professional prepare tax returns provides a number of benefits including: timely and accurate filing and avoid an audit.

Now that tax filing season is underway, many small business owners are gathering their financial information and planning to meet with a (hopefully) trustworthy tax preparer.

Having a qualified professional prepare tax returns provides a number of benefits including: ensuring the filing is timely and accurate, and avoiding an audit.

While only a small percentage of tax returns will be audited by the Internal Revenue Service, there are steps a business owner can take to minimize the chances of an audit.

Related Article: Accounting Mistakes That Put Your Small Business at Risk

How a Small Business Can Avoid an IRS Audit

The IRS usually conducts audits on a random basis, but mistakes and short cuts on a tax return can trigger enhanced scrutiny. Small business owners, particularly individuals with cash businesses, are low hanging fruit for the tax police.

This is because independent entrepreneurs may be more likely to underreport income, overestimate expenses and circumvent tax rules by having family members on the payroll.

Many small business owners operate from their home, but an individual needs to be careful about taking home office deductions. There are two standards for qualifying for a home office deduction:

First, you must regularly use part of your home, such as an extra room, exclusively for conducting business.

Second, you must show that you use your home as the principal place of business by having in-person meetings with clients, customers or patients.

Finally, there are limits to what a taxpayer can deduct for a home office, and these items, such as a phone, a computer, and other office equipment, must be used only in the course of doing business.

Related Article: Which is Better: Cash Or Accrual Based Business Accounting?

Other Audit Alarm Bells

There are other things that can trigger an audit. In particular, the IRS will look for red flags such as overestimated donations, underreported income and mathematical errors.

Overestimated Donations

Currently, federal tax law requires donors who claim a charitable contribution deduction of $250 or more to substantiate it with a "contemporaneous written acknowledgment" from the charity.

The taxpayer must receive this document either by the date the return is filed or the due date of the return, whichever is earlier. The acknowledgment must specify the name of the organization, the date of the donation, the amount of the contribution or a description of non-cash contributions.

The acknowledgment must also disclose whether or not the donor received any goods or services in return for the donation. If goods or services were provided to the donor, there must be a good-faith estimate of their value.

In particular, IRS auditors will take a close look at a business owner's non-cash contributions, such as office equipment and furnishings, to ascertain whether the value of these donations was overestimated.

Underreported Income

It is critical that all income you received for your goods and services are accurately reported. While most income is documented, whether on a form W-2 or 1099, or profit and loss statements, a business owner who receives a cash payment for services rendered may be tempted not to report the income.

It is always possible, however, that the IRS may audit the business that made the payment and thus find the unreported income. By failing to report income on a tax return you run the risk of being forced to pay back-taxes along with penalties and interest.

Related Article: 13 Genius Tax Write-Offs You Need to Take Advantage Of

Mathematical Errors

You are more likely to be audited if your return contains mathematical errors. These errors are often made in the valuation of capital gains and/or losses. For common financial investments, the maximum rate on long-term gains is 20 percent and applies to those in the top income tax bracket while those in the 25 percent to 35 percent brackets will be subject to a 15 percent long-term capital gains rate. Making these calculations often requires the expertise of an accountant who can ensure that the numbers add up. Even small errors can be a red flag for IRS auditors.

Higher Income

A small business that earns more than $200,000 per year is more likely to be audited. The risk of being audited is greater for income between $200,000 to $1 million and even more so for those earning more than $1 million. In other words, the more you make, the more they take.

Failure to Sign the Return

If you fail to sign the tax return, you can almost guarantee that the IRS will give the return a second look. Failing to sign might indicate that something else is missing from the return, like unreported income.

What Can I Do If I Am Being Audited by the IRS?

In the final analysis, a business owner may be audited if numbers on the tax return don't add up, if there is a lot of cash income, if there is a large discrepancy between the current year's income and that of previous years, if there are many deductions, and if tax forms and other required schedules contain inconsistencies. If you conduct business with other entities that are being audited, you are also more likely to hear from the auditors.

The potential for being audited can be nerve-racking, but business owners are entitled to tax-credits and deductions. That being said, the best way to avoid an IRS audit is to be honest and make sure your tax returns are accurate.

In the event of an audit, the only thing to do is deal with the situation by responding to all inquiries from the IRS as quickly as possible and retaining a qualified accountant or tax attorney.

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