Many small business owners often feel like they might be a heartbeat away from the IRS tax audit.
Read this article before your vivid imagination leaves your head spinning. The article will help you spot the most common IRS audit red flags and weigh the real chances of being audited. Read till the end and you will learn some top tips on what to do if you receive the IRS audit letter.
- What tax audit means?
- How is tax audit done?
- What happens after a tax audit?
- Can I use a tax audit defense?
- How many tax returns are selected for IRS tax audit each year?
- How does the IRS choose who to audit?
- What increases the chances of an IRS tax audit?
- How will the IRS conduct my audit?
- Will I get an IRS tax audit letter?
- How long does a tax audit take?
What is 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 tax audit means?
Tax audit is generally defined as an examination of your tax returns. It is 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,
- tax deductions.
How is tax audit done?
IRS tax audit happens via mail or in person (the so-called ‘field audits’). Tax auditors request a list of documentation they wish to examine and then compare the tax return to the business owner’s books for the year under examination.
And what happens after a tax audit?
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 helped you shake off the uncontrollable fear of an IRS tax audit. Now you are 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 low. Let’s have a look!
How many tax returns are selected for 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 data.
How does it happen? Well, computer programs screen for atypical 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.
What increases the chances of an IRS tax audit?
Accuracy is a matter of critical importance. If you want to minimize the chances of being audited by the IRS, be careful with numbers. The most common math mistakes that potentially can lead to audit are related to the income or other tax calculations and misreporting the number and amount of tax exemptions.
Want to keep these mistakes at bay? Do the following:
- 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 does not guarantee you will never undergo a small business tax audit, it does help you keep 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.
- File electronically. Electronic tax return filings are convenient and, in some cases, even required. It gives the 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 best fits your needs.
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 and estimate your chances of being audited.
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 they 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.
IRS audit trigger #2. Claiming Business Losses for Several Years in a Row
It is OK for small 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 IRS tax audit.
IRS audit trigger #3. 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, but you must report personal and business income accurately — no matter how high or low it is.
IRS audit trigger #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 lead to an IRS tax audit.
IRS audit trigger #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 calculations for your tax return. Otherwise the IRS might want to visit your lovely kitchen as well.
IRS audit trigger #6. Claiming 100% of Travel and Meals Expenses
Make sure you write off eligible travel and meals expenses to not trigger an IRS tax audit. You can deduct only 50% of these expenses and, in most cases, you are better off claiming the rest of your mileage at the standard IRS rate.
IRS audit trigger #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 if you don’t want to trigger an IRS tax audit.
How far back can a tax audit go?
If the IRS believes you made a mistake on your tax return, they will 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 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 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. Automated accounting systems will be of great help here. You will always keep your financial records accurate and at hand.
Having everything ready for an audit at all times helps to eliminate unnecessary stress and focus on other pressing issues.
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. Small businesses usually get audited by mail. In the previous 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 will 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 these 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. 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.
3 tips for a safe IRS tax audit
A tax audit is not usually something that we are 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 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 are 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 are 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 did not agree with the IRS auditor’s decision. And you have a right to disagree, as well. Tax experts will advise you on how to talk to the auditor 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. 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. 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 help you build a line of audit defense if needed.