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Red Flags that Might Increase the Risk of a Small Business Audit

Every small business owner dreads the idea of being audited by the IRS. Even if you have a good bookkeeping and accounting system in place and you are careful to follow the guidelines set by the IRS, there is a chance that you might face a business audit at some point.

It is challenging enough to run a small business and manage cash flow. Adding the stress of an audit on top of your current responsibilities can feel overwhelming. Luckily, you don’t need to handle the situation without support. The most important thing that you can do is hire a good accounting team to help with the auditing process.

Preventing a Business Audit in the Future

There is nothing that you can do to eliminate the risk of an audit completely. But, you should be proactive to minimize the risk so that you can prevent the possibility in the future. As with many other aspects of life, prevention is more valuable than dealing with a problem after the fact.

Talk to your accountant for recommendations about things that you can do to lower your odds of an IRS audit. Certain actions might raise a few red flags, resulting in a situation where the government takes a closer look at your business practices and transactions.

Red Flag #1: You Aren’t Turning a Profit

If you are writing off business deductions, then you need to show that you are working to bring in a sustainable profit. Tax deductions aren’t designed to cover hobby activities. So, a trend of non-profitability could make the IRS suspicious.

Your accountant can help you determine the right strategy to avoid this red flag. As a general rule of thumb, you need to be profitable for at least two out of five years.

Just because your business isn’t profitable, doesn’t mean that you shouldn’t take the deductions that are available. Most accounting professionals will recommend that you maximize your deductions as much as possible to leverage the tax benefits that are available. But, you need to be sure that you are managing good records to document the transactions in case any questions arise.

One or two years of business losses won’t be enough to raise a red flag for the IRS. Instead, they are looking for a pattern of loss that might indicate unusual activity. The IRS wants to be sure that you are taking deductions for a viable business.

Also, consider a new business strategy and cash flow management if you are spending in the red every year. Your accounting team will help you find the right solutions to minimize overhead expenses and maximize the money that you are bringing in. Sometimes a few small adjustments can go a long way to improve your profitability.

Red Flag #2: Most Transactions are Cash-Based

There is nothing wrong with accepting cash payments. But, it could cause a red flag if every transaction happens with cash. We live in a digital world, which means that many businesses are moving towards credit card and digital transactions.

The IRS might scrutinize your company a little more if everything is done in cash. This method of doing business increases the likelihood that business owners or employees could be taking a little off the top tax-free. It’s easier to hide money or adjust the numbers if the transactions are handed over in cash.

It might be tempting to avoid some of your tax obligations by sheltering some of the money that comes in. But, it isn’t worth the risk that you will be facing for penalties and fines if you are audited. Protect yourself and your company by keeping careful records of your cash transactions and the way the money is flowing in and out of your business.

Red Flag #3: Failing to Report All Your Income

The digital age in which we live has made it possible for the IRS to scrutinize the transactions a little more than before. Remember that you aren’t the only one sending the IRS information about your income. Other businesses are required to submit tax forms and paperwork regarding the transactions and payments that were made.

For example, if you offer a services-based company and you worked as a contractor for another business, then that company will provide tax information about the amount of money that was paid to you in a calendar year. Then, the IRS has a computer system known as the “automated underreporter” that compares various types of income reports with the tax returns that are filed. This IRS computer ensures that the numbers match with things like mortgage interest costs, W2 wages, and 1099 freelance income.

So, if you receive income, then make sure that everything is reported on the forms and tax filing. It isn’t worth the risk of withholding some of the information. If the numbers don’t match up, then it could trigger an audit, which in turn increases the likelihood that you will pay back-taxes and additional money for fees.

Red Flag #4: Unusual Deduction Activity

Are you inflating deductions? Some business owners are looking for ways to maximize deductions, so they work the numbers when it comes to things like cash contributions, unreimbursed business expenses, medical expenses, and more.

You should always claim every deduction for the costs that are incurred for business-related activities and purchases. But, if your deductions seem out of line for your industry, or you are claiming a lot more compared to other people in the same income range, then it could be a cause for concern.

Red Flag #5: High Home Office Deduction

If you work from home, then you need to be specific about the amount of space that is being dedicated for business use. This calculation needs to be based on the overall square footage of your home, as well as the amount of space that is needed for the business activities.

In the situation where a business audit is completed, the IRS wants to see that the home office deduction is legitimate. Is that space only used for business activities? Or, is it a place where the business and personal activities are mixed?

As you are calculating your home office deduction, your accountant will also help you look at details for the other home-related expenses, such as utility costs, HOA fees, and more.

Red Flag #6: Using Cryptocurrencies

Cryptocurrencies are relatively new in the financial world. But, it doesn’t mean that you don’t need to report income that comes from these sources. If you have any transactions that are done using cryptocurrency, then the income always needs to be reported.

Failing to report your income from these currencies means that you could be facing prison time and as much as $250,000 in fines. The punishment varies depending on the situation. But, it’s always best to report the income so that you don’t face any of these fines or jail time.

Red Flag #7: Expensive Costs for Business Travel, Meals, and Entertainment

Expenses should be deducted when you are on the road for business. But, it will raise a red flag if you are writing off high costs for lavish restaurants, entertainment, and more.

If you are going to use these costs as deductions for your business efforts, then you need to make sure that you always have good documentation about why you needed to travel. At the same time, be reasonable with the frequency of the travel compared to the needs of the industry.

Of course, these details change depending on your business and ongoing activities. Just be smart about the way you are writing off the meals, transportation, and entertainment. Any time you have questions about legitimate write-offs, it is a good idea to talk to your accountant for custom recommendations.

Red Flag #8: Claiming Vehicle Use is 100% for Business Activities

It’s hard to prove that the vehicle was only used for business, because it is natural to use a car for personal activities as well. So, it isn’t a good move to write off 100% of the vehicle costs. Instead, keep a log in the car of the number of miles that were driven and the purpose of the trip. Then, you can take a standard deduction based on the mileage rate.

This tracking can be as simple as a notebook and pen in the car. Or, there are apps that are available now that make it simple to punch in the mileage numbers so that you can keep a digital log.

Enlisting the Help of an Experienced Accounting Team

Whether you are facing an IRS audit or you are being proactive to minimize the risk of an audit, you need to be sure that you have a trusted accounting team to help with your business finances. These services offer a valuable way to protect your company and minimize tax burden at the same time. Learn more by calling our experienced team at Easier Accounting. We specialize in small business accounting services and offer year-round bookkeeping, tax preparation, payroll processing, and more. Call today to learn more: (888) 620-0770

IRS Audit: How to Survive the Stress of a Tax Audit

It often comes unexpectedly: you start a normal workday answering emails and talking with a few business contacts. Then, the mail delivery comes, and you find the dreaded notification letter from the IRS. They want to audit your company to make sure that the tax filings match your business records. This news can be terrifying for many business owners, and you might feel overwhelmed by thinking about the things that you will need to do to prepare for the audit.

There is no reason to stress if you have an experienced accounting team to help with your business finances. These ongoing services are essential so that you can stay current with the financial information for your company. At the same time, tax planning is important to reduce the likelihood that you will be audited.

Are You Running a High Risk of an IRS Audit?

How do you know if the IRS will be auditing your company? There is no certain way to determine if you will be the lucky person chosen for the auditing process. But, there are a few things that can be done to minimize your risk. An accountant can help you follow the important tax laws, helping you stay under the radar each year.

As a small business owner, you run a higher risk of an IRS audit compared to someone who files an individual tax return without business activity. This increased risk doesn’t mean that you shouldn’t be pursuing your business efforts. Instead, you need to make sure that you are maintaining the right reporting and documentation to back up the financial claims if an audit happens.

Here are a few other red flags that might increase the risk of an audit:

  • If your profits were between $200,000 and $1 million in a fiscal year
  • Being a property owner and reporting rental losses
  • Showing a history of unaccounted income changes each year
  • Hiding foreign bank accounts or transactions
  • Large donations to charitable organizations

Even if these factors apply to your business, it doesn’t mean that you will be audited. In fact, it is estimated that less than 1% of small businesses are audited each year.

What is the Purpose of an IRS Audit?

If you have been selected for an audit, then you are probably asking a common question: why does the IRS want to review my business financials? The goal of the audit is to ensure the accuracy of the reporting, helping to claim unpaid tax funds if the paperwork was filed incorrectly. It has been estimated that there might be as much as a $125 billion gap in unreported income by business owners.

Just because you have been chosen for an audit, doesn’t necessarily mean that there is a problem with your tax filing. Instead, the IRS is doing routine checks to ensure the validity of the paperwork that has been filed. The selection process is based on a few red flags that might come up in a computer screening. There is also a random selection element based on a statistical formula.

The algorithms compare your business tax return against the “norms” for other similar companies. If anything looks out of place, then you might be selected for the audit. You might also run a higher risk of an IRS audit if you have any relationships with transactions related to partners or investors who were also selected for an audit.

What to Expect with an Audit

After you have been selected for an audit, an experienced auditor is assigned to review your paperwork. Keep in mind that audit notification is always done by mail. You will never receive a phone call notifying you of the audit. There are common phone scams right now that claim that you are being audited, but these calls are hoaxes and should be reported.

The audit can be handled by mail, or they might schedule a time for an in-person interview. This interview can be scheduled in a variety of locations, such as the IRS office, your place of business, your accountant’s office, or at your home. When the letter arrives, it will have specific instructions that need to be followed, as well as the contact information to schedule the meeting if necessary.

For audits that are handled by mail, your notification letter will contain a request for additional information. The letter will specify the details that need to be provided, such as documentation for itemized deductions, expenses, or income.

Regardless of the way the audit is performed, you will need to provide the requested information. The records may vary depending on your individual circumstances. Sometimes electronic records can be provided, such as the reports that come from your tax software. Other times, hand-copy receipts might be needed. By law, you are required to maintain all of the records relating to your business. This information needs to be stored for at least three years after the filing of the tax return.

Tax Audit Myths

Don’t be fooled by some of the myths about tax audits. Here are some of the common misconceptions that small business owners hear about the auditing process:

  1. Myth: Your risk of an audit increases if you file an extension. The truth is that filing an extension is as easy as clicking a button on the IRS website. People who are in the military or living abroad automatically qualify for an extension. In the situation where you request an extension, it shows that you are thorough and careful with your tax schedule. So, it doesn’t impact your risk of being audited.
  2. Myth: More deductions will increase the chances that you are audited. As long as you are deducting transactions that make sense, they shouldn’t impact your risk of an audit. Something out of the ordinary might put up a red flag though. For example, if you spend $30,000 on new computers for an office with a hundred employees, then it will likely be viewed as a normal cost of doing business. But, $30,000 for a month of travel expenses and business meals for one sole proprietor might raise some questions.
  3. Myth: Amend your tax filing, and you will be audited. The IRS wants the tax filings to be correct, so they won’t punish you for an innocent mistake. If you are correcting your mistakes on a return that is e-filed, then it is viewed as a good step. Then, the filing will be treated as if it was a new submission and scans are completed to see if there is anything that looks unusual. In the situation where you need to change a filing, make sure that you provide thorough explanations for the adjustments.

What to Do if You Receive an Audit Notification

So, what should you do if you receive the letter in the mail saying that you are going to be audited by the company? The first thing is to take a few deep breaths and know that everything will be all right. If you are working with a good accounting team, then it shouldn’t be a hassle to provide the requested information. So, make sure that you are always staying current with your financial tracking to ensure that you are prepared in case you are audited.

An audit means that your files are going to be reviewed to make sure that everything matches your tax records. When you have good documentation, there is nothing to worry about!

Now that you know that there is nothing to stress about, it is essential that you contact your accountant right away. Together, you can verify that the request is an official document from the IRS, and not some type of phishing scam. Your accountant can help you see if the letter came from a documented IRS address.

You don’t need to carry the burden of navigating an IRS audit without the support from a financial professional. In fact, the outcome will be better if you lean on the expertise of your accountant during this process. Your accountant will understand the procedures and practices for IRS audits, and they can guide you through the steps to provide the information that is requested by the IRS.

An accountant will help you understand the audit and help you see any potential roadblocks that need to be addressed. Getting insight into the process will ensure that you are thoroughly prepared when it is time to sit down with the auditor.

It is important that you gather the requested documents. If you need to send the documents in the mail, then it is best to keep the originals and mail photocopies of the receipts and paperwork. You should always maintain the original documents in your files. Providing a detailed paper trail will ensure that the audit goes as smoothly as possible.

Do you have questions about tax planning, filing or audits? Then you need the support of an experienced accounting team. At Easier Accounting, we offer these services for small businesses and start-ups. Contact us to learn more about the ways that we can support your business efforts. We are here to help: (888) 620-0770

Is Your Company at Risk for an IRS Audit?

An audit can be a stressful and unpleasant situation to deal with, and many small business owners are worried that the IRS might audit their financial records. The likelihood of auditing varies depending on the type of business that you have and the numbers that are coming through on your tax return, and it is essential that you work closely with an accountant at all times. An experienced accountant can help you to avoid the audit in the first place, and they can assist with the required tasks if an audit occurs.

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Business Categories with a Higher Risk of Audit

The IRS does not share information about the types of companies that they audit. But, there are a few trends that have been noticed and it seems like certain categories have a higher audit risk. These are a few red flags that might potentially trigger an audit:

  • Small Companies: Generally, small companies don’t have good systems in place for financial tracking and records. It is also likely that the company doesn’t have a financial professional to help them stay in compliance with tax laws. The audit rate might be even higher if the company receives most income in the form of cash.
  • Business Travel, Entertainment and Meals: It is essential to have the paperwork to back up these expenses, and most small businesses don’t keep the proper records. If you are writing off large sums for business entertainment and meals, then the IRS might thing that you are writing off personal entertainment and calling it a business expense.
  • Schedule C Losses: Do you have a tax return that shows a high salary in conjunction with a Schedule C loss? This situation might be a red flag to the IRS. Typically, a Schedule C activity is a hobby instead of a business, especially if the activity is a personal pleasure, such as travel writing, photography, sports, etc.

IRS audits can be unexpected, and the best thing that you can do is hire a good small business accountant to ensure that you are staying within the tax laws. Prevention is the best solution, to help you avoid problems if your business is audited.

Here at Easier Accounting, we are experienced with all types of small business finance. We are here to help with anything that you need, and we invite you to contact our team to learn more about the services that are available. Call us right away: (888) 620-0770