It’s true that the odds of being audited are fairly low – under 1%. Yet this may not last long. The IRS has been changing some of its procedures – such as allowing agents to conduct audits via mail — and has also been increasing its hiring.
Besides, the agency tends to focus more on smaller businesses. Why? The assumption is that the recordkeeping is not as disciplined and business owners may be doing their own tax preparation, which could increase the risk of getting things wrong.
When it comes to audits, though, there is one important thing to keep in mind: the selection process is mostly done by a massive computer, which crunches huge amounts of data to find missing income and inconsistencies. All this is put into something called a DIFF (Discriminate Income Function) score. The higher it is, the higher is the chances the IRS will pick you.
No doubt, an audit is often a stressful experience as well as time-consuming and expensive (yes, the kinds of things that can be poisonous for a business). And if you lose to the IRS, the outcome could be devastating.
So what are some of the ways to help avoid the prospects of an audit? Well, there is nothing you can do that is full-proof (hey, we are dealing with the IRS here!) But there are some strategies that should help out:
Know The “Hot Buttons”: There are certain types of deductions and credits that raise questions, especially with the IRS computer. Often alarm bells go off when there are large amounts of items that appear to be personal, such as entertainment, meals and travel. But there are other deductions that can trigger scrutiny like casualty losses, health expenses and bad debt losses.
Now this does not mean you should avoid these. But rather you need to make sure you document the expenses and have a business purpose for each. This is where having a solid cloud accounting system – like QuickBooks or Xero – can be a godsend.
Something else: If there is a large amount of a certain type of deduction, then you might want to attach a statement that explains it and also provide copies of supporting documents (like receipts and checks). This may be enough to stop an audit when someone from the IRS reviews your return.
Don’t Miss Deadlines: A great way to help increase the odds of an audit is to not file your tax return. In fact, the penalties can be onerous. So even if you cannot pay your tax, you still should file your return. Period.
Report Your Income: I know there are times when it seems like it would be impossible for the IRS to know if a payment was for business or not. But keep in mind that the agency has spent years developing systems to detect unreported income.
Avoid Round Numbers: Yes, it seems the IRS computer will take this into account. Let’s face it, there would be understandable skepticism if you put $2,000 for meals and entertainment. It simply looks too contrived.
Self-Prepared Returns: Granted, applications like TurboTax are excellent. They use sophisticated analytics to check for errors and even provide you with the chances of an audit.
But software is never full-proof. If you provide the wrong information, then you may be get the attention of the IRS.
Instead, if your return has been prepared by a tax professional, then this should give the agency less confidence in pursuing an audit.
Hobby or Business: If your business looses money year after year, then the IRS will likely target you. The reason is that the agency may consider your operation a hobby, not a business. If this situation, you may have a large tax bill as you will lose plenty of deductions.
Then what do you have to do to be considered a business? First of all, the IRS will presume this if you report a profit for three out of the five past years, then you should have no problem. But if not, then you will need to provide convincing proof that your operation is not really just a way to reduce income from other sources. And this can be pretty tough to do.
Incorporate: The audit rate for those who file Schedule C’s is much higher than the average (at over 2%). Because of this, you might want to consider incorporating, such converting your business to an LLC, S Corporation or C Corporation.