November 2, 2020 By SmartBiz Team

The word “audit” can strike fear into the heart of even the most financially compliant small business owner. An audit can cause stress and mountains of frustrating paperwork. But there are ways to avoid an audit or successfully sail through one without costly penalties. Here’s information and strategies to help you through the process.

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What is a business audit?

A small business audit can be performed internally or externally. It’s a deep dive into your business's accounting books and tax returns determining accuracy and compliance with applicable laws.

An annual internal audit should be performed annually to make sure your business conforms with financial and reporting laws. An external auditor or IRS auditor might also audit your company but there are ways to prepare to avoid any problems.

Why do businesses get audited?

You, your bookkeeper, and any other financial professional you work with should be aware of the following reasons your business might face an audit.

Unreported income

You can become the target of an audit if the Internal Revenue Service (IRS) suspects you are hiding cash. Certain businesses receive a majority of revenue in cash. It might be an attractive prospect to "forget" to list the cash on your income tax statements, but you need to know that the IRS is very serious about these memory lapses and suspicion can cause an audit to be launched.

Failing to separate business and personal expenses

This is a big “no no”. All business owners should be adept at separating personal expenses and business expenses. Failing to do so is another reason you could could face an audit. Writing off things like vacations can’t be written off as a business expense, even if you preform business on your trip. Furniture tax is not deductible if you buy a comfy couch. These claims can raise a red flag and put you in the Internal Revenue Service’s sights. For more information about how and why to separate these expenses, visit the SmartBiz Small Business Blog: 4 Tips on How to Categorize Expenses for Small Business.

Reporting a net loss in more than two out of five years

If you can’t show three years of profits in a five-year period, you are likely to get audited. Experts advise business owners to follow the IRS publication 535 guide for expense reporting.

Consistently filing tax returns and tax payments late
Not following filing requirements and meeting deadlines is a red flag. Be sure to file for an extension if you can’t meet a deadline. Here are steps to take: Business Tax Extension: How to File for One.

High salaries paid to shareholders who are also employees

Determine reasonable salaries for your type of business based on industry, skill level, and geographic location. Unreasonable payments can trigger an audit.

Excessive deductions for business meals, travel and entertainment

Keep copies of receipts for all expenses, with detailed records, and don’t exaggerate these expenses.

Shifting income to tax-exempt organizations such as charities to avoid paying taxes.

This is considered tax abuse by the IRS. Review this document to understand the acceptable process: Tax Issues Relating to Charitable Contributions and Organization.

Claiming 100 percent business use of a vehicle

Make sure your vehicle is designated for business use. You should be able to show that there’s not another vehicle available for personal use. Business owners should maintain detailed mileage logs and calendar entries for each trip purpose.

Who performs a business audit?

There are two ways to perform a business audit – internally and externally. An external auditor follows specific laws or rules, examining the financial statements of a company and is independent of the business being audited. An internal audit is performed on your behalf to uncover any potential problems.

How do you prepare for a business audit?

If you’re going to handle the audit yourself, review in detail the returns being audited. Prepare to explain how you or your tax preparer came up with the figures.

Shoebox accounting – throwing all your receipts in a box or drawer to sort out later – won’t endear you to the auditor. Produce all records that substantiate your tax return as the IRS has a right to look at any records used to prepare it. Logically organize your records including receipts, checks, and other items. Just like grade school, neatness counts.

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How to avoid a business audit

Here are basic steps to take to avoid dealing with the IRS.

Respond to tax notices ASAP

It may be tempting to put unopened tax notices away in a drawer. Don’t do it. Have a system for opening important mail and taking action. A good strategy is to only handle a piece of mail once. Don’t put it in a pile.

Analyze your numbers

When someone issues you a tax form that reports income, such as a 1099, that information is also reported to the IRS, who will expect matching numbers on your tax return. A discrepancy could lead to a notice of audit.

Mistakes happen, so double-check any information you provide and also check your math. Best practices include using an accountant specializing in small business taxes or investing in tax preparation software.

Don’t report a loss each year

The IRS will only allow you to claim losses on your business for three out of five tax years or your operation might be considered a hobby. If you don't show profits, then the IRS can prohibit you from claiming your business losses on your taxes.

Keep organized records to help you report income and expenses accurately

Open a business bank account as soon as you establish your business. This minimizes your risk of an audit. Tax preparation will be simpler and you’ll have supporting documents if you get audited.

Your risk for an audit increases when you try to hide income or overstate your expenses. Rounding numbers to the nearest dollar is OK - rounding to tens or hundreds can give the IRS the impression that you’re winging it.

Don’t pay overly high salaries to employees who are shareholders

If you have a C corporation, paying your executives an unusually high salary is a sneaky strategy to minimize corporate profits so you are responsible for lower taxes. Research reasonable salary ranges in your industry, and don’t exceed it.

Be careful of independent contractors

If you have a high ratio of independent contractors to employees, the IRS might deduce that you’re trying to dodge payroll taxes. The IRS has clear guidelines on who can be an independent contractor and who must be classified as an employee. When in doubt, get small business advice from a financial professional.

Beware the home office write off

Home offices can be a red flag unless you take steps to prove your space legitimately qualifies. Our blog post, How to Take the Home Office Deduction, written by Jacob Dayan, CEO and co-founder of Chicago-based companies Community Tax and Finance Pal, outlines steps you must take to be compliant for this deduction. The most important information is this: the office space has to be 100% dedicated to and routinely (not just occasionally) used for business.

Pay your estimated small business taxes

Set aside 30 to 40 percent of your income to cover your federal and state taxes, due quarterly.

If you expect to owe at least $500 in taxes at the end of the year, you should be making quarterly estimated tax payments. If you don’t take this step, you might be on the hook for penalties or face an audit risk.

The bottom line

While and IRS audit is a legitimate business concern, you shouldn’t live in fear of the tax man. As long as you are keeping accurate records and not deliberately underreporting income or exaggerating expenses, your business should be in good shape to continue growing.

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