Is there an IRS audit in your future? Don’t simply hope the answer is no. How you handle your small business’ finances – in the way you spend money and how you document those transactions – can increase or minimize whether you’ll face IRS scrutiny. Focusing on red flags that’ll trigger an audit will help protect you and your business more efficiently. What the IRS says about the “examination process” includes a hopeful prospect: “Some examinations result in a refund to the taxpayer or acceptance of the return without change.”
Don’t count on it. And, remember: An IRS audit can inflict pain even if you come out smelling like a rose. The process of pulling together every financial record you need could put a strain on you and your bookkeeping department.
IRS Audit Triggers
So, what triggers an audit? General factors, according to the IRS, include the following:
This means: If the IRS audits one of your customers or suppliers, and asks questions about your tax returns, you might be next in line for scrutiny.
If there’s a discrepancy between your bank reports for the IRS (and you) and the interest it paid you over the course of the tax year, and what you report in interest income, a bright red flag goes up. Keep in mind that credit card transaction processors are required to file a 1099-K form to the IRS summarizing total payments you received that way.
Sometimes, regional IRS offices decide to focus on particular business sectors because it has found a lot of abuse there. There’s not much you can do to reduce your changes of an audit in this scenario.
Also, all things being equal, the type of business that you are – whether you’re a C Corp, or a Sub S or sole proprietorship – can affect your odds of being audited. That’s because it’s easier to blur personal and business finances when your personal and business finances are combined in a single tax return.
Another factor is the size of your business. The larger the company, the more money there is to be reclaimed by the IRS in a typical audit scenario if there’s any abuse. So, you’re more likely to stay below the IRS’s radar if your revenue is $1 million than if your revenue is $10 million. Even so, that doesn’t mean that you shouldn’t grow your business merely to lower your chances of an IRS audit.
Automated Audit Trigger System
The heart of the IRS audit process is called the “discriminant function system,” or DIF. The IRS assigns varying DIF scores to taxpayers–individuals and businesses–based on numbers and ratios they report. Like Google, the IRS doesn’t reveal anything about the DIF. Still, there’s plenty of evidence of where it focuses.
A basic example is the ratio of your total claimed business expense deductions to your overall business income. Of course, you can operate at a loss from time to time. But if that happens often, the IRS will probably take a closer look. Still, you’ll be vindicated if all of your expenses are legitimate.
The DIF focuses on areas typically prone to abuse, such as business meal charges and travel. If you frequently expense for these reasons, keep detailed records and receipts. This goes for expenses of at least $75.
Since 2018, you’re required to separate your food and drink expenses from the entertainment portion. The cost of the entertainment portion (e.g. theater and sporting event tickets) isn’t deductible. As always, keep notes on the purpose of business meals, who attended, and your relationship to those individuals.
Here are some additional areas of IRS scrutiny for statistical anomalies when looking for audit candidates:
Independent contractor overload.
If you use a lot of support from freelancers to whom you issue a 1099 instead of a W-2, this might trigger the IRS. Be sure you classify freelancers appropriately.
Home office deductions.
Remember: You can’t deduct the cost of an entire room if you’re only using the corner. The time you spend working in that room compared to everything else you use it for, matters.
Business use of a personal automobile.
This is an abuse-prone area, too, like food, drink, and entertainment expenses.
You might think an error involving an inconsequential amount of money isn’t a big deal. To the IRS (and probably the DIF system), small errors can be an indication of larger errors also present and worthy of discovery.
Large cash transactions.
In the unlikely event you are paid $10,000 or more in cash in a single transaction–and fail to report it on IRS form 8300–you could be audited.
There’s no set way of escaping the possibility of an IRS audit. But, by paying attention to red flags and preparing to answer possible questions about your expenses, you’ll save yourself a lot of grief in the long run.