The chances of the IRS randomly targeting your small business for an audit are low; the IRS typically applies scrutiny only when it picks up on red flags in your tax return.
What are those cues? Here are five signs that your small business tax return may prompt an audit, plus some tips for protecting yourself against one.
If You Filed a Schedule C
If you are a sole proprietor or single-member LLC, then as a self-employed individual you’ll have filled out IRS Schedule C to report your annual profit and loss. Unfortunately, Schedule C filers are more likely to be audited than other business owners, especially if your income is higher than $100,000. Good record keeping will help alleviate any IRS concern, but if your income is trending higher than that $100k mark, then you may want to consider incorporating as a C Corporation or S Corporation. Be sure to talk to a lawyer or tax advisor first, they can help you weigh up the pros and cons of each option.
Discrepancies between Income Reported on 1099s and Your Return
If your clients sent you 1099 forms reporting payment amounts made to you during the previous tax year, you need to make certain that the numbers in your return match those on the 1099. If you’ve kept good records this shouldn’t be too difficult but be on the lookout for discrepancies.
For example, if you received payment early in January for work done the previous year, but your client mailed the payment in December and recorded it on the 1099 form, you’ll still need to include the payment as it’s reported on the 1099 form, even though it would seem to inflate your taxable income for that year. To avoid this, subtract the payment from your current return and attach an explanation, then include that payment on that year’s tax return.
A Spike in Deductions and Expenses
If your expenses were a lot higher than previous returns, or what is considered typical for your type of business and income range, then the IRS may get curious. Again, recordkeeping is your friend. If you can, include documentation that evidences your claim and include an explanation of why the expense was “ordinary and necessary”, two key requirements for the IRS to consider a business expense as deductible. (According to the IRS: “An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.”)
It’s very easy to exaggerate small business tax deductions. For example, many business owners mistakenly assume that they can deduct 100% of meal costs while travelling, actually they are only partly deductible. The IRS scrutinizes a lot of commonly-claimed small business deductions, so be sure you understand what you can and can’t deduct, what percentage, and keep good records. Check out this brief video from Intuit on IRS Rules for Reasonable Business Expenses.
Failure to Report Cash Income
If you operate a service business such as a restaurant or store, or operate as an independent contractor, be careful about receiving “under the table” cash payments or failing to report payments for which you didn’t receive a 1099.
The Bottom Line: Manage Your Business Well Year-Round
An IRS audit is not inevitable and is actually your opportunity to show the IRS how you manage your business and explain your accounting methods. That being said, your best defense against an audit is to be prepared and manage your business effectively, year-round. This means keeping good books, thorough records, and getting the right tax advice.
Here are a few things you can do to help you do just that:
Save all your receipts.
Separate your business and personal income. For example, use a separate credit card for business expenses, not only will it make it easier to track your deductions and even claim any interest incurred as a deduction.
Record your vehicle odometer reading at the beginning and end of the year.
Familiarize yourself with what your small business can and can’t deduct for business travel.
Track your expenses as soon as they happen. A simple spreadsheet is all you need. Include the date, business purpose, who you met, miles travelled, and total expense.
Track and record all your income, including invoice numbers, date issued, and the date you got paid.
Know the rules about claiming the small business home office deduction.
Get advice about your business structure. You may find that and LLC or Corporation provides you with tax and liability benefits that you aren’t realizing now, they also generate fewer red flags with the IRS.
Disclaimer: The information in this blog doesn’t replace the advice of a tax or legal expert. If you have any questions about your small business tax situation, talk to a professional.