Internal Revenue Service (IRS) will flag businesses for an audit when the agency finds suspicious activity in your business’ tax returns. The suspicious activity may be innocent in nature, but IRS performs an audit to ensure your business paid the required taxes.
Though, occasionally, the agency will randomly audit businesses. This instance is less likely, but can still occur. It’s important to make sure your business is ready no matter the circumstances.
Oftentimes, businesses are more susceptible to an audit if they:
- Have foreign assets
- Have a cash business
- Are self-employed
- Have a home-based business
- Claim a disproportionate number of deductions
- File incorrect or incomplete returns
- Have a large number of cash transactions
- Earn less than $25,000 or more than $500,00
- File a Schedule C
- Claim a vehicle as 100% business expense
- File taxes late
The rate of audits rose by 50% in 2021, and are projected to stay on this upward trend as the government searches for ways to fund the proposed Build Back Better Bill. How can you prepare for a potential audit before it occurs?.
Signs Your Business is Prepared for an Audit
1. You Keep Organized Records
Recordkeeping is a fundamental part of being prepared for an audit. Keeping receipts, expenses, pay stubs, income, and other financial documents well-organized helps show the auditor proof of monetary movement that supports your tax file.
This documentation can be physical or electronic – as long as it’s there. Best practice is to keep the original and provide copies to the auditor in case of accidental damage or misplacement.
Audits typically go back three years, but at Milikowsky Tax Law we recommend you keep financial records up to seven years back.
2. Your W-2 employees and 1099 workers are correctly classified
W-2 employees and 1099 workers perform different roles for your business. Therefore, they must be classified accordingly. Misclassification can lead to fines, penalties, and even jail time.
Why? Because misclassifying an employee as a 1099 independent contractor strips the worker of employee benefits, and the government of payroll taxes associated with having a W-2 employee.
W-2 employees are hired for specific jobs, work set hours, receive benefits, and have taxes withheld from payroll.
1099 independent contractors work on a contractual basis, are paid a set fee, do not receive benefits, do not have taxes withheld, and have more work flexibility.
The “right of control” helps business owners determine worker’s status by answering three criteria:
- Behavioral Control: Are you in charge of the manner in which workers perform their duty?
- Financial Control: Do you pay regular wages and have the ability to fire the employee?
- Relationship to business: Is the employee an essential part of helping your business run?
Assembly Bill 5 (AB-5) implemented at the beginning of 2020, set regulations for 1099 independent contractor classification. Under the new law, all workers are considered W-2 employees unless the independent contractor meets all three of the following conditions:
- The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
- The worker performs work that is outside the usual course of the hiring entity’s business; and
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
Correctly classified W-2 employees and 1099 workers help you avoid further investigation and penalties in an audit.
3. You Use Deductions Claims Appropriately
Tax deductions are implemented to help businesses reduce their taxable income, but what qualifies as a proper deduction? Under IRS, the deduction must be ordinary and necessary.
According to IRS, “an ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.”
A few deductions small businesses can claim include:
- PPP loans
- EIDL and EIDL advance funds
- Office supplies
- Home office
- Repairs and maintenance
- Employee benefits
- Employee bonuses
- Employee wages
- Employee education
- Insurance premiums
- Charitable donations
- And more
When looking at claims, IRS matches claim amounts to total income received. If your total claims filed are too high, IRS will suspect some deductions were falsified.
Accurate claims combined with receipts that prove purchases set you up for IRS audit success.
4. You Filed Accurate Taxes
Accurate business tax files strengthen your case during an IRS audit. The auditor is looking for errors, omissions, and potential fabrication during the audit process.
Oftentimes, audits arise because simple mathematical mistakes throw off numbers. By double-checking your return and using exact numbers when you file your taxes, your business will be better prepared for a potential audit.
During the process, they will crossmatch your business returns and look to see if your business reports match the total income reported by you and by your W-2 and 1099 workers.
5. You Know When to Use a Trusted Attorney
A trusted tax attorney can help build your case in the face of an IRS audit. Their expertise will help you:
- Prepare legal defense
- Review your documents to identify potential errors or issues
- Handle discussions with your auditor
- Represent your business before IRS
- Develop legal theories that may include “reasonable cause” defense
- Help you improve the chances of a successful audit
Have more questions about IRS audits? Read our article here answering the top 7 questions we receive about IRS audits.