10 Tips to Avoid an Audit on Your Small Business Tax Return
— January 3, 2019
Just hearing the word “audit” is enough to make a person’s blood run cold. And if that person is a small business owner, there’s no doubt why: When the IRS wants to audit your business tax returns, that means you’ve got a lot of receipt-collecting and explaining to do.
Generally speaking, small business owners—like all Americans—are very rarely audited. In fact, the IRS is auditing fewer tax returns than ever these days, so the majority of the millions of small businesses out there can rest easy, assuming they were truthful on their returns.
That doesn’t mean small business owners can play loose with the rules. For one thing, though audits are rare, small businesses owners and self-employed individuals are slightly more likely to be audited than the general public. Sole proprietors, in particular, get flagged more often than others.
Plus, in order to get through the millions of returns they need to review, the IRS has triggers that automatically flag a return for an audit—regardless of whatever valid excuse you might have.
While an audit doesn’t mean you’ll automatically owe the government fines or interest money (or even face time behind bars), audits are always worth avoiding. Here are 10 tips to help you do just that:
File on time and file completely
Let’s start with the most obvious: If you don’t want to raise suspicions, you need to file a tax return every year, even if your business didn’t turn a profit. Failing to file a return, or filing an incomplete return, is perhaps to the most glaring sign that you’re trying to hide something.
Report the right numbers
You aren’t the only source of information on your financials for the IRS. Other parties—such as employees or vendors—will report what you paid them. If you’re a self-employed freelancer, the IRS will receive copies of W-2s and 1099s. If you’re a sole proprietor, your Schedule C needs to have all of your profits and losses for the year.
It’s one thing to make a simple math error on your returns. It’s another to completely fudge or alter your numbers deliberately. The IRS will be able to compare what you report to what they have on file, so don’t even try it.
File your estimated taxes on time
Whether you’re an independent contractor or a business owner with dozens of employees, it’s crucial that you file your estimated taxes each quarter. Know the deadlines for each quarter (typically midway through April, June, September, and January of the following year) and make complete payments to federal and state governments to avoid their ire.
Don’t abuse your business deductions
As mentioned above, businesses have more opportunities to take deductions than individuals do. If you don’t have deductions to take, however, don’t take them: The IRS is going to flag unlikely tax deductions.
For example, anyone who writes off 100% of their personal vehicle costs is inviting scrutiny. Even if you used your car often for work, are you really claiming you never used it to go grocery shopping or take a trip? Same goes for your home office, which must be a separate room used entirely for business—not your couch.
Another common deduction that people overuse is business dinners: You can’t write them off entirely, and it doesn’t give you carte blanche to go all out every time you get together with a client.
Avoid reporting only nice, round numbers
A common practice of people who are either making up numbers completely or trying to remember expenses and income from memory is to use consistently round numbers. While rounding up to the nearest dollar is fine, listing expenses that only end in 0 or 5 (as in $ 125, or $ 2000) looks suspicious at best.
Don’t report a personal lifestyle that doesn’t match your income
The IRS reviews your personal tax return along with your business return, so they should be congruous. If you personally live lavishly—reporting the purchase of a boat, or fancy car—while your business doesn’t turn a profit, the authorities will wonder what the disconnect is.
This is sometimes an issue that cash-heavy businesses have, especially when they fail to report all of their earnings. Be sure to report all of your profits, especially if failing to do so will result in an imbalance between your personal and business tax returns.
Your business shouldn’t have lower margins than similar businesses
While not every business in the same niche will perform exactly as well as its competitors, unusually low annual sales or profits compared to your peers in the industry—especially when your business assets and bank balances stay stable or increase—is a red flag.
Your business shouldn’t consistently lose money
Not every year is a good year for your business. Whether because you made a lot of important long-term investments this year, or sales took a hit following an interruption in business, there may be years that you file your business taxes stating a loss.
If that happens more than a couple of years in a row, however, the IRS is going to wonder how you’re staying in business despite reporting losses year after year. The likeliest reason: You’re taking in cash profits that you’re not reporting.
Don’t show an enormous change in income without documentation
If you’ve been showing decent profits the last few years, only to suddenly post a massive uptick this year, that’s going to catch attention. Of course, that doesn’t mean “Avoid making a big profit,” but be prepared to show your work: Document whatever steps you took or expenses you made that led to your success, including receipts and invoices.
Don’t rely too heavily on independent contractors
Misclassifying workers is a common way to avoid paying state payroll taxes, such as disability insurance and unemployment—and the IRS knows it. A business that solely employs independent contractors may be enough to trigger an audit.
If you enlist independent contractors, make sure they qualify for that status, rather than as full-time employees.
The best way to avoid an audit is to file your taxes on time, accurately, and with integrity. By following the above steps, you should avoid any accidental triggers that can bring undue scrutiny and slow down your day-to-day operations while you deal with the inquiry. And hey, if you still get pinged, get together with your accountant and start gathering everything the IRS requests. It’s nothing personal—just business.