Why IRS is Planning to Audit More Small Businesses This Year

Late in 2020 IRS announced that they intended to increase audits of small businesses by 50%. This news came as a shock to many small business owners who were still attempting to recover from the economic downturn brought on by the COVID-19 pandemic. While many businesses have struggled to hold on, and others closed their doors permanently there were a handful of industries whose revenues actually increased despite their early concern that they would be negatively impacted.

While IRS tax audits are daunting, there are ways to protect yourself from the negative outcomes of an audit including fees, penalties, and even jail time. 

Maintain Good Records 

Keeping good records can make the difference between being audited by IRS and coming out the other side with reduced or non-existent penalties… or not. IRS looks for businesses and individuals whose returns are inconsistent with their income and information. Incorrectly declaring your income or claiming deductions that are not applicable to your business are sure ways to have IRS take a closer look. 

Maintaining clean records facilitates fewer errors on your returns. Whether intentional or not, identifiable mistakes are a flashing red light for IRS to investigate. 

Utilizing a reputable bookkeeper or CPA can help keep your records in line to avoid errors and ensure that all legal deductions are taken.  Business owners have a wide array of totally legal deductions that can offset higher taxes, a qualified CPA can guide you to the right write-offs. Having a CPA that’s already familiar with your business can be an augmentation to your current strategy in the event that your business is audited by IRS. CPAs and tax attorneys create a partnership that will provide significant benefits to business owners in the case of a tax audit. 

Make sure you’re claiming proper deductions 

Taking advantage of as many deductions as possible is well within the legal scope for businesses. Be sure that you make use of any opportunities to save money by working with your CPA to help them understand your business structure, acquisitions outside of regular business dealings, any employee benefits changes you have made, and more. 

IRS attempts to identify taxpayers who have made incorrect claims or deductions and often chooses to audit those returns. In the event that a business or individual has claimed deductions that they are not eligible for, they may have done so repeatedly and over a prolonged period of time. In these cases, other discrepancies can be uncovered during the audit process, increasing the liability of the business owner being audited. 

Make timely payments 

Individuals, including sole proprietors, partners, and S corporation shareholders, generally have to make estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed.

Corporations generally have to make estimated tax payments if they expect to owe a tax of $500 or more when their return is filed.

When estimated your expected tax payment, IRS suggests using Form 1040-ES to correctly figure your estimated tax. It may be helpful to utilize income, deductions, and credits for the prior year as a starting point when estimating your expected tax payment. 

Estimated taxes are due on a quarterly basis. If you didn’t pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax.  

Make sure to correctly classify any independent contractors

While employing independent contractors may be critical to the success of your business model, you should be very careful in doing so. IRS uses specific rulings to determine whether a worker should be classified as an employee or an independent contractor. 

If it is found that you may have incorrectly classified your workers as independent contractors, the Employment Development Department (EDD) will likely partner with IRS to perform an audit. 

Some triggers that might lead to an audit of this nature include an independent contractor applying for unemployment, for which they are ineligible, or having a significantly higher number of independent contractors than full-time employees. In some cases, businesses may utilize this as a tactic to avoid paying additional taxes. 

The consequences of an underpayment or misclassification will depend on whether the auditor finds the discrepancies to have occurred intentionally or unintentionally.

Unintentional misclassifications may result in a $50 penalty for each W-2 form that was not filed for an employer classified as a contractor. The employer also faces penalties of 1.5% of employee wages to compensate for income tax withholding, 40% of employee payroll taxes, 100% of matching employer payroll taxes plus interest on each of these penalties, and a Failure to Pay Taxes penalty of 0.5% of the unpaid tax liability for each month delinquent.

Intentional and fraudulent misclassifications may result in additional penalties, such as 20% of all wages paid and 100% of payroll taxes — employer and employee share-alike. Criminal penalties, including a $1,000 fine per misclassified worker and up to one year in prison, may also be imposed. California employers can see total fines of up to $25,000 per misclassification violation.

If you are a small business and have recently prepared your annual tax return, you may be at risk of an upcoming audit. In the event that you receive an audit notification from IRS, you should reach out to an experienced tax attorney immediately. Our team of tax professionals at Milikowsky Tax Law has significant experience defending businesses in tax audits. We help keep businesses in business. Contact us today to get started.