Say the word “audit,” and small business owners run for cover. Nothing generates as much fear as the prospect of having to come before the IRS and defend a business's tax records.
Even if everything is in order, the audit process is stressful, time-consuming and costly. But what are the chances that your business will be audited?
IRS Audit Rates & Red Flags
About one percent of personal returns are subject to an IRS audit, but the odds increase with business returns, especially as your business income rises. Some business returns are chosen randomly for audits; others are hand selected.
Apparently, no one knows for sure exactly what triggers an audit. But at Fox Business’s Small Business Center, tax expert Bonnie Lee says there are some red flags. A few of the obvious tip-offs that can cause the IRS to flag your return:
- Your income doesn’t match the 1099 totals;
- You exceed the IRS’s industry standards for average expenses;
- You have big numbers in categories like travel, meals or entertainment; and,
- You prepared the return yourself.
Minimize Your IRS Audit Risk
The tax code isn’t getting any simpler and changes all the time. To keep your ducks in a row (and the IRS away), consult periodically with an attorney and tax professional to make sure you’re not only minimizing your audit risk but also that you’re taking full advantage of potential tax rates.
But even with sufficient attention to tax detail, a certain percentage of small business tax returns will be audited. If you’re among these, the legal site nolo.com advises business owners to first, don’t panic. Second, prepare, prepare, prepare. Much of this advice is common sense.
IRS Audit Preparation
You can go it alone, the site says, but who would want to? Wouldn’t anyone benefit from having their tax professional/preparer with them through the audit process? Anyway, preparation is much the same either way.
Review your returns being audited and make sure all the figures can be substantiated. Ideally, you have plenty of documentation, including receipts, checks and any other items that apply. The IRS will want to see all of it, so make sure everything’s organized and logical (This is the IRS, after all).
Lee stresses neatness, too, because it will help streamline the review process and builds your credibility in the eyes of the IRS. If you have good records, agents are more likely to give you the benefit of the doubt. But the opposite is true if they have to dig through messy records.
With An IRS Audit, Documentation Is the Key
It’s a no-brainer that the IRS wants written documentation of your expenses. But they can accept verbal explanations, too. If you get an audit notice, there should be a list of what documents to bring to the audit:
- Bank statements, cancelled checks, receipts. You can also use hand-written notes or a notebook if you paid for some things in cash.
- Electronic records, such as credit card statements, with the name, date, amount and address of each payee. Don’t forget to provide electronic records relating to your business loans as well.
- Books and records. Small businesses aren’t required to keep formal books. But the IRS will want to see whatever you do have if you don’t keep ledgers and journals—pc/printout, checkbook register or cash register tapes. Without these, the IRS can estimate and even impose extra penalties.
- Calendars, appointment books, logs. Believe it or not, this can help justify your expenses should you find yourself face-to-face with an IRS audit.
- Records for listed equipment (for both business and personal use). Cell phones, cars and computers are the most common. Include copy machines, high-tech calculators, or any other equipment you use in the day-to-day operations of your small business.
- Other documentation:
- Auto records: Mileage log, gas and repair receipts can all come in handy when dealing with an IRS audit.
- Travel and entertainment: If you’ve kept an appointment book or log and copious notes of your activities and expenses, yay. Otherwise, put together the best documentation you can. BUT—don’t try to fudge it or fool the IRS, Lee says. You’ll lose your credibility, and it’s downhill from there.
- Record of business rental expenses, noting how much you paid to whom and when.
More IRS Audit Tips from the IRS Itself
Go to IRS’s website and you can learn even more great tips to help you in the event that you’re faced with an audit. For instance, when organizing your records, in addition to categorizing them based on what they’re for, group them by year as well. And if you have time, write up a summary list of transactions so the auditor can easily see what they were.
Some audits are conducted by mail and others are done in person. If you’re chosen for a mail audit, make sure you get them the requested documentation by the deadline provided. Should your IRS audit be in person and you need more time, contact your auditor directly to make the request. If he or she doesn’t work with you or respond, the next step is go to the auditor’s manager.
Although the IRS can decide to audit any return within the previous three years, they sometimes go back six years and look at tax returns completed in that timeframe. Most audits don’t cover returns older than that, but when in doubt, check with your tax preparer or the IRS before destroying any records.
Finally, should you disagree with the audit findings, you do have the right to request a conference with an IRS manager, ask for mediation, or file an appeal.
If you find yourself among the to-be-audited, CNN Money says there is a small bright spot. Now small business owners, like their mid-size and large counterparts, can file for a fast-track settlement, meaning that it can all be settled in 60 days. Plus, the site says, furloughs and budget cuts at the IRS have resulted in declining audit rates!