The IRS has increased enforcement efforts aimed at small business returns, including S-corporations, LLCs, partnerships and sole proprietors. You can lower your odds of a tax audit by taking specific steps with your tax return and avoiding others.
Hire a reputable CPA
Finding the right CPA for your business can make all of the difference in the world. Find a CPA that has an excellent reputation among other business owners. Check out their online presence via their website, search online reviews to get a good feel for the firm. CPA’s are required to complete at least 40 hours of continuing education each year. CPA’s typically have greater liability concerns, so they make sure to produce high-quality work. Tax rules that affect small businesses are incredibly complex. Having a qualified CPA to prepare your returns can significantly reduce your risk of an audit.
Hobby or Business
Is what you are doing a hobby or a business? If your business looks more like a hobby, you could trigger an audit, lose all your deductions and end up owing IRS tax on all the income without getting to offset the income with deductions.
The expression "if it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck" applies in this situation. Does your business behave like a business, spend like a business and act like a business that is designed to earn a profit?
File accurate returns
Incorrect or sloppy returns and rounded numbers raise red flags. Do not guess! Using a competent professional tax preparer helps you avoid mistakes. Keeping good records is essential. If the IRS audits your return, the burden will be on you to prove that you can substantiate your deduction. Keep your documents organized and neat. It is a good idea to scan supporting documents and keep a backup at a separate location.
Report all income
The IRS intently looks for unreported income. If you fail to report any income documents such as Form 1099’s that report income under your social security number, then the IRS will want to know why. The IRS has compiled data on typical income levels and deductions for every type of business. If your income or deduction is not consistent with similar companies, it increases your chance of being audited.
Do not forget to report barter income. The fair market value you receive through business barter transactions must be reported. If you sell items on eBay or another online site, this needs to be reported.
Do not comingle personal and business deductions
Be sure to have a separate business checking account and credit card. Use the business accounts only for business and the personal accounts just for personal. Do not mix and match the two. If you run personal expenses through your business accounts, then it adds an extra layer of scrutiny to all deductions that you may claim as a business. The IRS is always on the lookout for small business owners who try to deduct travel, entertainment or other costs that are personal, and not business related.
Have clear and concise deductions
Far too often we see categories such as "miscellaneous" or "various". Avoid these vague categories. If your business is claiming an unusual deduction, provide an explanation or documentation.
Make sure that your income to expense ratios make sense
The chance of being audited increases if the difference between expenses and income seem inconsistent with other businesses in your industry. This includes total deductions or an unusually large deduction. If you claim lots of expenses but show little revenue to pay for them, you have a good chance of getting audited.
File all tax returns, payments, and required business forms on time
If your tax return is late, it raises flags. You can file for an extension. There is an old rule of thumb that filing an extension will reduce your risk of being audited. Just be sure that you do pay any taxes that are due when filing the extension to avoid additional penalties and interest.
File all required payments, payroll reports, and business forms.
Most taxpayers understand the need to file a yearly 1040 tax return. When you own a business, you have other obligations that must be met. These are just as important to file timely.
These obligations include quarterly reports for corporations or estimated tax payments for sole proprietors. Non-payments and underestimated payment amounts could draw the eye of the IRS.
Obligations can also include filing 1099’s and W-2’s timely and accurately. If you do not, this can also flag your return for an audit. Far too often we see incorrect amounts or amounts entered in the wrong box on a W-2 or 1099.
Correctly classify independent contractor/employee
If your business uses independent contractors, do you know if they qualify as an independent contractor? Should you be treating them as an independent contractor or an employee?
The IRS has strict guidelines that must be met. A reputable CPA can help you go through the checklist to make sure that your contractors are not actually employees. If the IRS determines they are in fact employees rather than contractors, then you will have to pay back payroll taxes.
Depreciate or expense
Some items cannot be expensed all in one year. Many business owners assume that money spent in a tax year can be deducted immediately. However, that's not always the case. Do you have startup costs or purchases over $2,500? These may need to be depreciated.
Depreciation rules it feels are continually changing. Under the new tax act of 2018, there are many significant changes regarding depreciation. It is essential to depend on CPA’s, who are well educated on the ins and outs of these rules.
Home office
A home office deduction has specific requirements that must be met. It must be an entirely separate room or area used exclusively for business. Not all home expenses are eligible to be deducted. Depending on your business type you may also need to take depreciation on your home. Here again, a CPA can be invaluable in helping you do it right.