Tips to Avoid a Tax Audit and What to Do if One Happens to You



how to avoid an audit

Audit. It might be the most intimidating five-letter word in the English language. Just the thought of the IRS painstakingly combing through your records and receipts is enough to scare many small business owners into a state of paralysis. Fortunately, there are things you can do to both avoid getting audited in the first place and to survive one if it does happen.

Be Careful and Meticulous with Your Tax Returns

It may go without saying, but the IRS really does look at the tax returns you file. When discrepancies pop up, they become red flags that can lead to the dreaded audit. For this reason, it’s important to be sure that your paperwork accurately reflects any income reporting forms such as 1099s that third parties may have filed.

In addition, simple mathematical errors can skew your numbers and lead to warning bells at Uncle Sam’s revenue headquarters, so check your numbers two or three times for accuracy before you file.

Don’t Report Losses Year after Year

Hard times can befall even the most successful retailers and small businesses, and the IRS is sympathetic, allowing you to record your losses when tax time comes. However, if you report net losses in more than two out of five years, the IRS might start to think your business is just an insignificant hobby. In the end, they might disallow all of the business deductions you have requested.

Separate Business from Personal

When it comes to bank accounts, mingling your individual assets with those of your company should be avoided at all costs. It’s an easy trap to fall into, especially if time is short and you are doing a lot of multi-tasking. However, you are sure to regret it when tax time rolls around.

Instead, set up a separate account for all of your business holdings. Make it a priority to accurately report all of your company expenses and to document them with receipts. That includes receipts for any POS payments your business receives. In the unlikely event that an audit does occur, these will be invaluable as supporting evidence.

Finally, avoid the temptation to round your expenses to a large extent. Rounding to the nearest dollar is fine, but anything more than that can suggest that you are fudging your data.

Use Moderation in Setting Salaries

Of course, you want to compensate your employees for a job well done. However, some business owners fall into the trap of paying overly high salaries to their C corporation shareholders. By so doing, the amount of company profits that can be taxed is reduced, a situation that can often lead to IRS suspicion. Take some time to look at what people in your industry are making. Then compensate your people accordingly, not being either too stingy or overly generous.

Don’t Rely Too Much on Independent Contractors

Anytime you use the services of an independent contractor, you are not required to remit payroll taxes; that responsibility falls to the contractor. For that reason, many businesses use the services of these non-employees to a great extent. This is a red flag to the IRS and might result in an audit, so use independent contractors judiciously.

Be Careful about Home Offices

If you have high expenses for items such as utilities and equipment for your home office or if you also rent a second space, the IRS might decide to give your tax return a more thorough look in the form of an audit. Although requesting a deduction for a home office is perfectly legal, the space should be a separate room that is not utilized for any other purpose. Also, be sure to hold onto receipts for any of the home office expenses you are itemizing.

Pay Quarterly

If you anticipate that you will pay at least $500 in business taxes at the end of the year, you should be filing quarterly estimated payments. Failing to do so can definitely put you high on the to-be-audited list.

If an Audit Does Occur

No matter how meticulous and organized you may be, there is still a small chance that you will be chosen for an audit. In most cases, these procedures simply involve the IRS calculating how much tax you owe and ensuring that your payments are up-to-date. If you get that dreaded audit letter, don’t panic. Instead, follow these suggestions:

  • Look carefully at your IRS audit letter. In many cases, the process happens completely through the mail. If that is the case, give yourself the time you need to gather the pay stubs, receipts, bank statements and invoices they are requesting. Then submit them in a timely fashion. Procrastinating will only magnify the seriousness of the situation. If an in-person audit is requested, the IRS representative should be able to tell you exactly what documentation is needed and how long the audit will take.
  • Understand the procedure. You have been audited for any number of reasons, and it is your job to prove and explain your claims. Perhaps your expenses rose or fell dramatically; maybe your revenues are much lower or higher than usual. You may have simply made an error in your calculations. Whatever the reason for the federal scrutiny, be calm, polite and thorough, and give the officials any and all evidence to back up your claims.
  • Be patient. Audits can take several months, sometimes even longer than a year. Often, you will be visited more than once. Between visits, the data you submitted will be carefully reviewed before the next step is taken. Because a resolution can be slow in coming, your stress level may ramp up with the passage of time.
  • Expect a financial burden. The longer your audit takes and the more complicated it gets, the more of your precious time is needed to accumulate documents and otherwise address IRS concerns. As a result, you have fewer hours to devote to your business. If you begin to notice that this is taking a toll on your bottom line, consider hiring someone to deal with the auditors, thereby allowing you to re-dedicate yourself to your other responsibilities.

For most small businesses, audits are a nightmare that never become a reality. Do all you can to decrease your chances of generating red flags that could bring on extra federal scrutiny. But if you do receive an IRS audit letter, rest assured that as long as you devote time and effort into satisfying the officials, the situation will be resolved.