Last year was rich in government financial aid programs, like PPP loans or EIDL. They helped entrepreneurs stay afloat during Coronavirus lockdowns. As the tax season came around, the other (not so exciting as getting financial aid) side of the story became evident: tax returns. Forgivable loans have changed the tax landscape. Several states are still staying quiet about their local regulations. Many business owners feel like they might be a heartbeat away from the IRS tax auditor knocking at their door.
Read this article before your anxious imaginings start causing you headaches. You will learn the most common IRS audit triggers. The article will help you weigh the real chances of being audited by the IRS. Read till the end, and you will find top tips on what to do if you receive the IRS audit letter.
What is a tax audit
The idea of meeting a tax auditor sounds scary. It’s like a boogie man for grown-ups. But knowing what a tax audit is will make the thought less frightening. This chapter will give you a quick overview of what to expect if the IRS audit letter pops into your mailbox.
So what is an audit?
A tax audit is an examination of your tax returns. It is performed by the IRS tax auditors. Their job is to verify that the financial information you reported to the tax agency was correct.
During an IRS audit process, the auditor will check whether an individual or business returns comply with federal or state tax laws. They will examine reports regarding:
- taxable income,
- tax deductions.
What does the audit process look like?
Tax audits by the IRS happen via mail or in person (field audits, as the IRS calls them). Tax auditors request a list of documentation they wish to examine. During an audit, the controller will compare the tax return to the accounting books for the year under examination.
And what happens after a tax audit?
The tax controller will either verify the correctness of your accounting statements or find 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 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 helped you shake off the unruly fear of a tax audit. Now you are ready to dive into details and learn more about the whole tax audit process.
Chances of being audited
The biggest question that concerns most business owners is, of course, what are the odds of getting audited anyway. Figures show that your chances of being audited by IRS are low. Let’s have a look!
How many tax returns are selected by the IRS for audits each year?
As per IRS compliance presence reports, for all returns filed during the last decade, 0.60% of individual and 0.97% of all corporation returns were examined. So, statistically, the chances of IRS audit for you are almost non-existent. But if we look at 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 randomly or because a computer picked up something outstanding in your data.
How does it happen? Well, computer programs screen for outlier returns based on a statistical formula. If your tax return deviates from the norm for small businesses, the chances of an IRS 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.
What increases the chances of IRS audit?
The overarching theme is accuracy. If you want to minimize the chances of being audited by the IRS, be careful with numbers. Math error notices are the most popular IRS auditing tools today. The most common math errors relate to the income or other tax calculations and misreporting the number and amount of tax exemptions.
To keep math error notices at bay:
- Upgrade to automated accounting software and forget about Excel spreadsheets. Even adding an extra digit to expenses may result in an IRS audit letter. While accuracy does not guarantee you will never undergo a small business audit, it does help you keep financial statements matching. If your accounting is accurate, you won’t pay penalties after an audit. Be careful with importing payment data into the accounting system and set your mind at ease. That is exactly how Synder, a five-star synchronization app, assists small businesses and accountants. It would be wise to give it a try.
- File electronically. Electronic tax return filings are convenient and, in some cases, required. It gives IRS fast access to 100% of your return. In nearly every instance, online tax-filing solutions have ways to check your information for errors. By using the built-in tools, 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 fits your needs the best.
Now you understand how the tax agency chooses bounce candidates for closer examination. Move on to the next chapter to learn about the triggers and estimate your chances of being audited.
Red flags for the IRS audit
As you already know, statistically, the chances of IRS audit for small businesses are low. But some factors could increase the odds of being singled out for closer scrutiny. Let’s see what they are.
What triggers an IRS audit?
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 get red-flagged for an audit.
2. Claiming Business Losses for Several Years in a Row
It is OK for businesses to claim a loss in the first few years as you are just starting to generate revenue. But if you continue claiming business losses year after year, it can be suspicious enough to warrant an audit.
3. Reporting Higher Income
Unexpected higher income levels may trigger IRS algorithms as well. We don’t suggest not reporting higher income if you have one, but you must report personal and business income accurately — no matter how high or low it is.
4. 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 attract an audit.
5. High Home Office Deductions
If you work on your business at your kitchen table while you have breakfast, you should not attempt to deduct your kitchen as a home office. If you do have a legitimate home office, be accurate about the square footage when you do your calculations for your tax return.
6. Claiming 100% of Travel and Meals Expenses
Make sure you only write off eligible travel and meals. You can deduct only 50% of meals and travel expenses conducted for a business. In most cases, you are better off claiming your mileage at the standard IRS rate.
7. Mixing personal and business deductions.
The IRS is on the lookout for small business owners who try to deduct travel, entertainment, or other costs that are personal and not business-related. Don’t try to use hobby expenses to claim a business loss.
How far back can IRS audit
If the IRS believes you made a mistake on your tax return, it will examine your documentation to make sure everything was accurately reported. The biggest question here is how long should you keep your tax records in case of an audit. Let’s find out.
How many years back can the IRS audit?
Generally, IRS audits returns filed within the last three years. If a tax controller identifies a substantial error, they may add additional years. The auditors don’t usually go back more than six years.
The best method to pass through a tax audit process frictionlessly is to track all your business income and expenses and keep a record of all your tax documents for seven years. Automated accounting systems like QuickBooks connected to payment providers will be of great help here.
With the help of automated software, you will always keep your financial records accurate and at hand. Having everything ready for the audit will help eliminate unnecessary stress during the IRS audit process.
IRS 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 examination by the tax agency looks.
How am I getting audited by the IRS?
Tax audits are interviews either via correspondence or face-to-face. Small businesses usually get audited by the IRS through the mail. In the previous year, correspondence audits by the IRS prevailed: 73.8% compared to 26.2% in person.
While field interviews are the rarest, they turn out to be the most scrutinous. Tax returns examined by tax controllers in person result both in more additional taxes and tax refunds for taxpayers.
Will I get an IRS audit letter?
First of all, the IRS will contact you by mail regardless of what kind of audit awaits you. You will get a notification of a possible mistake or issue with your tax return. The audit letter will provide all contact information and further instructions.
If your audit is to be conducted completely by mail, the auditor will request a list of documentation they wish to examine. If you have too many books or records to mail, you can request a face-to-face audit. Either way, follow these instructions and carefully compile and organize the requested information. Showing up to the audit with the legendary shoebox full of receipts will not be to your advantage.
What is the IRS audit process timeline?
No single answer for everyone. The IRS’s job is to check if there are errors on the tax return for the audited year. The 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 sheets 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 timeline of the process is the availability of all the information requested. Your agreement or disagreement with the findings may also shift the timeline to a greater scale.
3 tips for a safe IRS audit
A tax audit is not what we are usually looking forward to. Keeping your mind off of troubles is tempting unless you want to run a successful business! Even if your chances of being audited by the IRS are low, you should learn how to deal with tax representatives. Here are the best 3 tips to pass the IRS audit smoothly and safely.
Explain yourself clearly to a tax auditor
When being 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 directly to the questions, and don’t try to explain more than what is being asked.
Automate accounting instead of keeping receipts in a shoebox
Rather than focusing on the fear of an audit, first, get rid of the habit of shoebox bookkeeping.
Make sure you are accurately recording and reporting your business income and expenses each year. Accounting software and automation services will help you through the complex accounting process. Knowing that all your financial statements are neat and accurate will ease your fears of tax audits.
Get tax audit representation
If you have doubts about how to behave during the auditing process, the best thing to do after receiving the IRS audit letter is to contact a tax professional for assistance. Audit representation, also called tax audit defense, is 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 did not agree with the IRS auditor’s decision. And you have a right to disagree, too. Tax experts will advise you on how to talk to the tax controller without getting defensive or hostile. A sound communication strategy will work in your favor.
It is easier to go through the whole auditing process when you know what to expect. Stop exhausting yourself with anxious imaginings and non-existent boogie men. The auditors are regular people doing their jobs. When you understand what their jobs are, far-fetched fears roll away. You can prepare yourself morally and be ready to defend your business with the necessary documentation.
Pay attention to how you do your bookkeeping. Adopt tech solutions to avoid unnecessary mistakes that may make your files red-flags to the IRS computer algorithms.
Don’t hesitate to turn to tax experts who can help you build a line of audit defense if needed.