As a small business or sole proprietorship, taxes are unavoidable. Paying your taxes correctly and on time is important to your business — after all, the last thing any entrepreneur wants is to face an audit from the IRS! A tax audit is (almost) completely preventable: not only can you minimize your risk by filing on time, but there are certain tax audit triggers or “red flags” that the IRS looks for when determining who to investigate.
Being conscious of these potential eyebrow-raisers can help you adjust your filings accordingly and fly under the radar. Here, we’ll discuss the top three business audit triggers the IRS will be looking for, how to avoid them, and how to prepare for an audit if they’re inevitable for your business.
If you’re a sole proprietorship and you report a loss to the IRS, your chance of audit is extremely high. This is because sole proprietorships are especially suspicious to the IRS since owners often intermingle their personal and business expenses, taking deductions larger than they’re entitled to. Unless you’re keeping rigorous, detailed financial records, it’ll be very difficult to justify your deductions to the IRS, causing you to potentially lose out on entire deduction categories.
So, what do you do if your business comes up in the red at tax time? We recommend taking a close look at your deductions, making absolutely sure that they’re allowed under the tax code. While it’s tempting to treat every dinner out as a business expense, you need to examine whether each and every expense you claim is valid as a business expense. This is also a good time to make sure that all your financial records are easily accessible and in chronological order, as the IRS will ask you to turn them over in the event of an audit.
While a loss on a sole proprietorship is usually a red flag, there is one notable exception: if you’re a startup that takes a loss its first year, you’re unlikely to be audited. That said, it’s always better to be prepared for the worst while expecting the best, so make sure that you’ve accounted for your startup expenses properly. Businesses are required to capitalize certain expenses, spreading the deductions for some large expenditures over multiple years. Unless you’re a total tax wizard, this may not even occur to you to do, which could set you in the IRS’s sights. Visit www.irs.gov for more information, or consult a tax professional if you have questions that need specialized answers.
It can be tempting to round down your cash transactions, but don’t think that just because you received payment in cash that the IRS has no way of tracing it! Credit card processors now submit 1099-K forms to the IRS, which include a record of the total credit card transactions your business processed for the year. Using these figures, the IRS applies a (secret — no one knows the specific formula but them!) formula to calculate how much a business should have produced in cash sales.
So what does this mean for your business? If you report cash sales for a lower figure than their formula determines, you could be putting yourself at risk for an audit. To avoid this, keep detailed records of your cash transactions as well as credit card payments, that way you can support your claims in the event of an audit. Don’t make the mistake of assuming you’re in the clear — good documentation can make all the difference if you find yourself being audited.
You may find yourself flagged for an audit if, for example, you’ve tallied your credit card receipts and they don’t align with the figure on the 1099-K. The IRS is always — we repeat, always — checking the math on your returns, so it’s mission critical to get the numbers right. Once you’ve ensured that all your deductions are valid and supported by your financial records, apply that same attention to detail to your calculations and double-check them.
It’s helpful that most tax returns nowadays are done electronically, allowing the tax prep software to do your math for you. Still, it’s a good idea to do a once-over and make sure that all the numbers make sense — knowing your numbers is a part of knowing your business. Once you sign that tax return, you’re responsible for all the numbers it contains, including the math.
You may have noticed a running theme: the best way to prevent an audit or defend against losing deductions to one is to keep detailed, accurate financial records. These records will serve as your justification for the deductions you take and shield you from losing part or all of your deductions.
The best way to defend yourself against audits is to strictly separate your business expenses from your personal finances. This means using separate credit cards for business and personal expenses, as well as recording business and personal mileage separately.
It should be noted that audits usually occur between two and three years after you file a return, and reconstructing your records years later can be difficult. It’s a good idea to prepare your books (or electronic records) each year as if you were expecting an audit, that way you’ll be prepared in the event that you are examined. After all, much worse than the audit itself is the pain of not being prepared for it.
If you’ve never experienced the pain and suffering of recreating a year’s worth of records 2 years after they occurred, then rest assured you NEVER want to. It is a near certainty that unless you’ve kept meticulous records and have a bulletproof filing system something will get lost, misplaced or damaged over time. Having digital backups certainly helps in the event of an audit but how you get from paper to digital backups is the big question. Neat of course provides several mechanisms to capture business expense including traditional scan, email-in or mobile capture. We encourage those working in the field to capture as you go using mobile. This eliminates the possibility of receipts being left in a car/truck only to be thrown out or lost. Lost receipts in the field are a common and significant way a small business will under-report deductible expenses. So when you get that receipt in hand at the supply store, gas station or other – snap a pic and be done with it.