IRS Audit Red Flags: How to Avoid Getting Tax Audited by the IRS

Many small business owners often feel like they might be a heartbeat away from the IRS tax audit.

In fact, according to the IRS data, only about 1 percent of taxpayers are facing an audit. If you’re a small business owner, however, your chances are a bit higher – about 2.5 percent of small businesses are getting tax audited.

What’s interesting is that the less income you have, the higher the chance of a tax audit. This might be explained by the fact that lots of these taxpayers file for a tax return and claim the earned income tax credit ranging from from $560 to $6,935 in the tax year 2022. The IRS pays closer attention to such cases to make sure that there’s no fraud in claiming the earned income tax.

Read this article before your vivid imagination leaves your head spinning – it’ll help you spot the most common IRS audit red flags and weigh the real chances of being tax audited, as well as provide you with some top tips on what to do if you receive the IRS audit letter. Ready? Let’s dive in!

Contents:

1. What is a tax audit?

2. IRS tax audit process

• How will the IRS conduct my audit?
• Will I get an IRS tax audit letter?
• How long does a tax audit take?
• What happens after a tax audit?
• Can I use a tax audit defense?

3. Chances of getting an IRS tax audit letter

• How many tax returns are selected for the IRS tax audit each year?
• How does the IRS choose who to audit?

4. IRS audit red flags: What triggers a tax audit?

5. What decreases the chances of getting audited by the IRS?

6. How far back can a tax audit go?

7. 3 tips for a safe IRS tax audit

What is a tax audit?

Meeting a tax auditor is as frightening as meeting a ghost. But knowing what a tax audit is can make this encounter less terrifying. This chapter will give you a quick overview of what to expect if the IRS tax audit letter pops into your mailbox. 

What does a tax audit mean?

A tax audit is generally defined as an examination of your tax returns. It’s performed by the IRS tax auditors, whose job is to verify that the financial information you reported to the tax agency was correct.

During an IRS tax audit process, the auditors check whether an individual or business returns comply with federal or state tax laws. They examine reports regarding:

• taxable income,
• losses,
• expenses,
• tax deductions.

IRS tax audit process

Each year a certain number of tax returns are selected for a compliance check by the IRS. If you happen to be among them, you should know what to expect. Keep reading to find out how the general process of the IRS tax audit goes.

How will the IRS conduct my audit?

IRS tax audits can be managed either via correspondence or a face-to-face interview (the so-called ‘field audits’). Small businesses usually get audited by mail. Last year, correspondence audits prevailed: 73.8% compared to 26.2% in person.

While field interviews are quite rare, they turn out to be the most meticulous. In-person tax returns examinations may result both in additional taxes and more tax refunds for taxpayers.

Will I get an IRS tax audit letter?

First of all, the IRS will contact you by mail regardless of the type of audit. You’ll get a notification of a possible mistake or issue with your tax return. The tax audit letter will provide all contact information and further instructions.

If your audit is to be conducted by mail, the auditor will request a list of necessary documents. If you have too many books or records to mail, you can request a face-to-face IRS tax audit. Either way, follow the instructions and carefully compile and organize the requested information. Showing up to the audit with the legendary shoebox full of receipts will not play in your favor.

How long does a tax audit take?

There’s no universal answer. The auditor’s job is to check if there are errors on the tax return for the audited year (years). The tax audit timeline depends on the type of audit and the complexity of the issues.

Tax auditors will go through your financial statements, such as your profit and loss statements and balance sheet for each year under examination. Other source documentation, such as invoices, receipts, and bank statements, might also be required. 

Among other things that influence the IRS audit process timeline is the availability of all the information requested. Your agreement or disagreement with the findings may also either extend or shorten the process.

What happens after a tax audit?

The tax auditor either verifies the correctness of your accounting statements or finds a mistake. In the latter case, you might have to pay additional taxes, as well as penalties and interest. A mistake can be in your favor, then you may get a refund. Actually, more than 26,000 of the taxpayers audited by the IRS in the last fiscal year got approved tax refunds.

Can I use a tax audit defense?

Every individual and business undergoing a tax audit process can use authorized assistance for their tax audit defense. The law guarantees you a right to use help from an authorized tax expert. You also have a right to appeal disagreements, both within the IRS and before the courts.

We hope this quick overview has helped you shake off the uncontrollable fear of an IRS tax audit. Now you’re ready to dive into details and learn more about the whole tax audit process.

Chances of getting an IRS tax audit letter

The biggest question that concerns most business owners is, of course, what the odds of getting audited are. Figures show that your chances of being audited by the IRS are quite low. Let’s have a look!

How many tax returns are selected for the IRS tax audit each year?

As per IRS compliance presence reports, for all returns filed during the last decade, only 0.60% of individual and 0.97% of all corporation returns were examined. So, statistically, the chances of an IRS tax audit of your business are vanishingly small. But if we look at the real numbers, that stands for 200,000 to 800,000 tax returns carefully examined by the tax agency each year. 

How does the IRS choose who to audit?

The IRS uses various methods to choose which tax returns to select for examination. These methods include random sampling and computerized screening. It means you can either be picked for an IRS tax audit randomly or because a computer picked up something odd in your tax data.

How does it happen? Well, computer programs screen for atypical tax returns based on a statistical formula. If your tax return deviates from the norm for small businesses, the chances of an IRS tax audit increase.

Your tax returns may be selected for auditing for a related examination as well. It may happen if your business partner or investor is getting audited by the IRS. 

Now you understand how the IRS chooses candidates for a tax audit. Move on to the next chapter to find out more about the audit triggers or red flags and estimate your chances of being audited.

IRS audit red flags: What triggers a tax audit?

As you already know, statistically, the chances of an IRS tax audit for small businesses are low. But some factors can increase the odds of being singled out for closer scrutiny. Let’s see what these IRS red flags are.

IRS audit trigger #1. Using round numbers

Most people tend to use round numbers when they make estimates. Be sure that the IRS knows this. Expenses ending in zero might be a tax audit red flag – pretty numbers suggest that you aren’t careful with your money. The IRS might want to review your records and check your profile.

IRS audit trigger #2. Claiming business losses for several years in a row

Businesses are created to make money. It’s OK for small businesses to claim a loss in the first few years as you’re just starting to generate revenue. But if you continue claiming business losses for years, it can be suspicious enough to warrant an IRS tax audit.

IRS audit trigger #3. Not reporting all your income

Not reporting all your income when you file your taxes is quite a common reason for a meticulous audit. Tax authorities are very strict in dealing with such unscrupulous taxpayers. In fact, not reporting all of your income opens Pandora’s box and can even lead to a prison sentence.

IRS audit trigger #4. Reporting higher income

Unexpected higher income levels may trigger IRS tax audit as well. We don’t suggest you shouldn’t report higher income if you have one – unreported income flags IRS audit and results in serious consequences. You must report personal and business income accurately — no matter how high or low it is.

IRS audit trigger #5. Taking big deductions

Taking several substantial deductions may be a solid reason for scrutiny. While deducting business expenses from a tax return is a legal method of saving money, claiming multiple large expenses may lead to an IRS tax audit. This doesn’t mean that you should fear claiming deductions – just be more careful. Review the way you do your income tax returns – making errors on your tax return may result in unnecessary problems. 

IRS audit trigger #6. High home office deductions

If you work on your business at your kitchen table while you have breakfast, you shouldn’t attempt to deduct your kitchen as a home office, that’s one of the most wide-spread red flags out there in post-lockdown times. If you do have a legitimate home office, be accurate about the square footage when you do calculations for your tax return. Otherwise the IRS might want to see where you live and your lovely kitchen in particular to check how good of a taxpayer you are, and whether your deductions aren’t claimed fraudulently.

IRS audit trigger #7. Claiming 100% of travel and meals expenses

Make sure you write off eligible travel and meals expenses  in deductions not to trigger an IRS tax audit. Taxpayers can deduct only 50% of these expenses and, in most cases, they’re better off claiming the rest of their mileage at the standard IRS rate. If you claim 100% of your travel and meals expenses, the IRS will take notice. Are you sure an expense like that is worth a stressful audit and penalty?

IRS audit trigger #8. Mixing personal and business deductions

The IRS is on the lookout for taxpayers who try to make deductions for travel, entertainment, or other costs that are personal and not business-related. Don’t try to use hobby expenses to claim a business loss if you don’t want to trigger an IRS tax audit. Taking too many deductions to inflate your losses will definitely result in unnecessary attention from the IRS. Trying to save money this way may lead to lots of stress.

IRS audit trigger #9. Hiring more individual contractors instead of employees

This one’s tricky: in such cases state tax agencies are more likely to trigger an audit by notifying the IRS. Businesses that look to employ more contractors than employees don’t pay state and federal payroll taxes and may seem suspicious to the state. While some taxpayers misclassify their workers to save money, the two agencies work in close cooperation with each other to impose penalties and make sure the taxes are paid. Don’t worry, you can still use the services of independent contractors – check that your business complies with  the IRS worker classifications and your state’s standards, and consult with a lawyer.

IRS audit trigger #10. Reporting large amounts of cash transactions

This trigger usually concerns offline businesses who accept mostly cash payments. Cash is king, but it’s complicated to track – taxpayers need to have detailed records that usually extend to paper receipts. However, if your online business has a physical store and you operate not only, let’s say, in cards, but also in cash, and report huge amounts of cash transactions, that’s a red flag. In such situations a taxpayer must be ready to provide the IRS with thorough documentation.

What decreases the chances of getting audited by the IRS?

Accuracy is a matter of critical importance. If taxpayers want to minimize the chances of being tax audited by the IRS, they should be careful with numbers. The most common math mistakes that potentially can lead to a tax audit are related to the income or other tax calculations and misreporting the number and amount of tax exemptions.

While there’s no insurance against a tax audit, you may minimize the number of mistakes in your tax records and reduce your chances of being tax audited. Want to keep the mistakes at bay? Do the following:

Use automated accounting software

Upgrade to automated accounting software and forget about Excel spreadsheets. Accidentally adding an extra digit to your expenses may result in an IRS tax audit letter. While accuracy doesn’t guarantee you’ll never undergo a small business tax audit, it does help you keep years of data at hand and financial statements matching. If your accounting is impeccable, you won’t pay penalties. Be careful with importing payment data into the accounting system and put your mind at ease. 

Check out Synder’s functionality and see how easy data import is. Subscribe for a free trial or schedule a demo with a specialist to find out what this automated software can do for your business.

File electronically

Electronic tax return filings are convenient and, in some cases, even required. If you file electronically, it gives the IRS fast access to 100% of your tax return. In nearly every instance, online tax-filing solutions have ways to check your information for errors. By using the built-in tools to file, you can ensure that your data is accurate. There are plenty of free online tax filing sites and professional tax filing software available on the market. Choose the one that best fits your needs and file your taxes from the comforts of your office or home.

Hire a professional tax preparer

Hiring a tax professional helps your business avoid unpleasant surprises come tax season and live your life free of stress and fears. These services might be costly, but they’re worth every penny – you’re confident that your business is tax audit proof. Having a tax preparer at your service does pay off.

How far back can a tax audit go?

If the IRS believes you made a mistake on your tax return, they’ll examine your documentation and check the accuracy of your reports. The biggest question here is how long you should keep your tax records in case of a tax audit. Let’s find out.

Generally, IRS audits returns filed within the last three years. If the auditors identify a significant error, they may add additional years, but usually they don’t go back more than six years. 

The best way to have a clean tax audit is to track all your business income and expenses and keep a record of all your tax documents for seven years. 

Having everything ready for an audit at all times helps to eliminate unnecessary stress and focus on other pressing issues. This is your insurance against sleepless nights and whopping penalties. 

3 tips for a safe IRS tax audit

A tax audit isn’t usually something that we’re looking forward to. Keeping your mind off troubles is tempting, but if you want to run a successful small business, you must be vigilant! Despite the fact that your chances of being audited by the IRS are quite low, you should learn how to deal with tax representatives. Here are the top 3 tips taxpayers need to know if they want to have a clean IRS tax audit.

Explain yourself clearly to a tax auditor

When interviewed by a tax auditor, avoid vague categories (such as the infamous ‘miscellaneous’). If your business is claiming unusual deductions of some kind – anything an IRS reviewer might not have come across a thousand times before – back up your explanations with documents. Answer the questions directly, and don’t elaborate unless you’re asked to.

Automate accounting instead of keeping receipts in a shoebox

Make your life easier and stop focusing on the fear of an IRS tax audit. Get rid of the shoebox!

Make sure you’re accurately recording and reporting your business income and expenses each year. Accounting software and automation services will help you get through the complex accounting process. Knowing that all your financial statements are neat and accurate will definitely give you peace of mind. 

Get tax audit representation

If you have doubts about how to behave during the tax audit, the best solution is to contact a tax professional for assistance. Audit representation, also called tax audit defense, is the practice when an authorized legal professional stands on your behalf during the IRS tax audit.

An audit representative may help you develop the strategy to defend the position of your business. 2.6% of the examined taxpayers last year didn’t agree with the IRS auditor’s decision. And you have a right to disagree as well. With a tax expert at your service, you’ll get advice on how to talk to a tax auditor without getting defensive or hostile. A sound communication strategy will work in your favor.

Bottom line

It’s easier to go through the whole auditing process when you know what to expect. Prevent your imagination from running wild and stop falling prey to your fears. Ghosts are scary, but non-existent, while auditors are just regular people doing their jobs. When you understand what they do, far-fetched fears fade away. You can brace yourself and be ready to defend your business with all the necessary documentation.Pay attention to how you do your bookkeeping and adopt tech solutions to avoid typical mistakes that may trigger IRS tax audit red flags. Don’t hesitate to turn to tax experts who can provide you with useful advice and help you build a line of audit defense if needed.