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Meredith Wood

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Are You at Risk for a Small Business Audit?

August 14, 2017

Reduce the likelihood of the IRS showing up at your company.

The dreaded small business audit. Many business owners fear an audit by the IRS more than any other obstacle they might face. This fear—or at least, this level of fear—is largely unfounded.

At its core, an audit is simply a “second look” by the IRS on a business’ tax return. The auditor compares the return to the business’ books, ensuring there are no discrepancies or other errors. Most audits are completely random, as the IRS selects a certain number of returns each year as a compliance check. 

This is similar to a quality control measure in your business: Just as you can’t check every product your business manufactures or screen every interaction your team has with a client, the IRS can’t thoroughly examine every tax return submitted. However, you would be remiss if you didn’t review a sample of your product or your customer service interactions. So, it is with the IRS and small business audits.

How to Trigger a Small Business Audit

You might have noticed I said “most” audits are completely random. There are some things you can do that increase the chances the IRS will pull your return aside for a closer look. Following are some missteps you can easily avoid.

  • Not reporting officer wages if your business is an S-corporation. If your business is taxed as an S-corporation, then you must pay yourself a salary before any non-wage distributions are made. Submitting Form 1120S without an entry for officer wages could very easily land your return in the “to audit” pile.
  • Using round numbers. Bookkeeping typically isn’t very high on a business owner’s to-do list. If you don’t delegate or outsource the bookkeeping for your business, you might be tempted to “guesstimate” some of your expenses at tax time. Most people tend to use round numbers when they make estimates, and the IRS knows this. You don’t have to report your income and expenses to the penny—in fact, most tax software automatically rounds to the nearest dollar. But if you submit a tax return where all the income and expenses are in multiples of $100, your return might get flagged for an audit.
  • High meals and entertainment expenses. This one can get tricky. Meals and entertainment expenses are legitimate business deductions, provided you can prove the expenses are ordinary and necessary. Fear of an audit should not prevent you from deducting these expenses, but make sure you keep good records detailing the nature of the expenses. These records should include the names of the people or group in attendance and the business relevance of the meal or activity. If you are deducting meals for yourself during travel instead of meals with clients or prospective clients, note the nature of the travel. 

    Notice I didn’t mention how to substantiate your expenses for your daily trip to the local coffee shop or the lunch you purchase for yourself each workday. While most tax preparers report these expenses under meals and entertainment, the lunches and snacks you purchase for yourself—outside of travel away from your local area—are not legitimate tax deductions. This is an area the IRS has started to scrutinize more carefully, so use caution if you have gotten into the practice of claiming these expenses on your tax return.
  • Home office deductions. As with meals and entertainment expenses, home office deductions are legitimate tax deductions. The caveat here is your home office must be used “exclusively and regularly” for business. Your home office should be a designated area in your home and a legitimate workspace. In other words, if you work on your business at the end of the kitchen table while you have breakfast each morning, you should not attempt to deduct your kitchen as a home office. If you do have a legitimate home office, be honest about the square footage when you do your calculations for your tax return.
  • Vehicle expenses. Unless your vehicle is owned by your business (meaning your business’ name, and not your name, is on the title), avoid claiming 100% of your automobile expenses are for business use. In most cases, you are better off tracking and claiming your mileage at the standard mileage rate the IRS publishes each year than claiming your actual automobile expenses.

The list above is by no means an all-inclusive, but you might have noticed an overarching theme: honesty. While honesty does not guarantee you will never undergo a small business audit, being truthful on your tax returns will set your mind at ease.

Small Business Audit Survival Tips

Since most small business audits are random, nothing you do guarantees you will never undergo one. Following are some small business audit “survival tips”:

  • Keep good records. You should have documentation for every deduction you claim on your tax return. The IRS does not require receipts for most expenses under $50 … but it’s a good idea to keep them anyway. There are numerous apps you can use to capture your receipts using your smartphone or a scanner, and then your receipts will always be available in case you need them. Likewise, a number of good apps exist for tracking mileage, to ensure you aren’t tempted to guess at your business mileage expense come tax time.
  • Understand your tax return. Many business owners are only concerned with one number on their tax return, and that is the amount owed to the IRS or due as a refund. This is a mistake. You don’t have to know all the ins and outs of the tax code—after all, this is why you hire a professional to prepare your return for you—but you should review your return and ask questions before signing and submitting your return. Most tax preparers are honest, but there are some who—either intentionally or through a lack of knowledge—file incorrect or even fraudulent returns. The IRS does not accept lack of knowledge as an excuse if a return is found to be incorrect during an audit, so understanding your return is essential.
  • Be prepared. The IRS will notify you in advance—and in writing—of your audit date and the year under examination. This gives you time to compile your records. Having everything at hand for the audit helps the process go more smoothly.

    Part of the preparation process is to isolate the year under examination in your accounting records. The auditor only examines your records for the tax year in question. However, if they happen to spot something in another tax year that looks suspicious, your simple one-year audit could be expanded to include multiple years. Isolating the tax year in question in your accounting records—either by creating a period copy in desktop software or by downloading the records for that specific year if you use a cloud accounting platform—is, therefore, a very good idea.
  • Have your tax professional and bookkeeper present. If at all possible, ask the tax professional who prepared your return and your bookkeeper to be present during the audit. They can quickly answer any questions the auditor has about your return and your bookkeeping, thereby speeding up the audit process.
  • Be nice to the auditor. IRS auditors have a tough job. The taxpayers whose returns they review are often defensive at best and hostile at worst, and they deal with this work environment every day. Being nice to the auditor smooths the audit process for everyone involved. Just be careful not to be venture into an area of niceness that can be construed as bribery.

A small business audit is never “fun,” but there is no need to fear the possibility of one. As long as you are honest about your income and deductions, keep good records, and ensure you are comfortable with your tax return before submitting it, you can put your mind at ease about the possibility of an audit and focus on the more important aspects of running your business.

This article originally appeared on Fundera.com.

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