Scared of a small business tax audit? Learn how to prevent this dreaded small business issue.
No one wants to go through a small business tax audit. Taxes are already stressful, and you don’t want to have to review them feeling like a cold IRS agent is breathing down your neck, just waiting for you to make a mistake.
Thankfully, with the right steps, you can usually avoid a tax audit. In this guide, we’ll discuss what you need to know, including what triggers a tax audit and what you can do to avoid one.
For small businesses, tax audits are actually pretty uncommon; only a very small fraction of returns get audited. But if you’re notified that you’re being audited, your initial reaction might be panic or dread — especially if you did your utmost to file a good return. But let’s be clear: getting an audit doesn’t necessarily mean that there was an issue with your return. That’s because there are two primary causes that trigger a tax audit. (See tax audits definition)
The fact is, the IRS randomly selects returns to audit each year, regardless of whether that return has issues or not (selection is based on a statistical formula). So you could just be the “unlucky” one who gets audited. Another common cause for an audit is when the IRS notices a discrepancy between your return and another tax form they receive. There are a few other “red flags” that could trigger an audit, too.
There’s no way to guarantee that you’ll never be audited, but you can greatly reduce the risk by following a few strategies. We also highly recommend getting advice from a licensed CPA or tax attorney to get individualized advice for your unique business.
If your business will owe $500 or more in taxes, then you’ll be expected to make quarterly estimated tax payments. If you don’t, the IRS may suspect that you’re underpaying on your business income taxes (or worse, committing tax evasion) and investigate.
It’s unrealistic for the IRS to investigate every single tax return with a fine-tooth comb, especially when millions come flooding in on April 15th. If you file late or even request an extension for extra time, however, your return is more isolated — and more likely to be flagged as problematic.
For many small business owners, tax time is overwhelming and stressful because there is so much data to collect, add, and input. While it’s tempting to get your taxes over with as quickly as possible, it’s best to take your time to double-check all your numbers. Even if it’s not a substantial error and it’s just an honest mistake of transposing numbers, it can be an audit trigger.
Technically, you’re allowed to report business losses on your tax returns; after all, they happen sometimes. But it’s considered best practice to avoid repeatedly reporting losses on your business tax returns. Repeated losses can make the IRS suspect that your business is merely a hobby, or that you’re abusing the business form as a means to evade taxes.
How often do you go to the store and see a round number on your receipt? Probably never, or only extremely rarely. So if you report a bunch of round numbers for your business expenses, your tax return may look fishy. Instead, keep detailed, accurate financial statements of your actual expenses and include those on your tax returns.
The home office deduction is a completely legitimate practice, but only if you do it correctly. Make sure the home office space is used exclusively for the business. And be sure to deduct the right percentages of qualifying expenses, matching IRS guidelines. If in doubt, consult with a tax professional for customized guidance for your home office deductions.
Deductions are a business’s best friend for reducing their taxable income. But if you report your deductions incorrectly — especially if you overestimate them — you open yourself up to potential audits. Keep accurate records of your expenses so that you can prove your deductions match your actual business circumstances. This includes mileage deductions for using your personal vehicle for business purposes, equipment costs, and so on.
For more information on the different deductions you can make, check out our guide on small business tax deductions.
A lot of small business owners hire independent contractors to get help with business tasks without the expense and hassle of hiring employees. And if you’re legitimately hiring contractors, then that’s perfectly legitimate. But you can’t classify an employee as a contractor to avoid your employment tax liabilities. That’s against the law and a surefire way to get audited.
Cash transactions are legitimate, but generally they’re a lot harder to track and prove, as they’re much more ambiguous on your bank statements. Having an excessive number of cash transactions can raise red flags, especially for large transactions.
If you’re taxed as a C corporation or an S corporation, then you’re allowed to pay your corporate shareholders a salary. But paying too much or too little of a salary to your business partners can cause problems, signaling that you’re dodging certain taxes. For example, C corporations could potentially dodge income taxes by paying an unreasonably high salary to their qualifying shareholders. LLCs taxed as S corporations could dodge a portion of self-employment taxes by paying too low of a salary.
In general, the IRS expects you to pay a “reasonable salary” to your members or shareholders (qualifying business structures only). Keep your salaries in line with industry standards, and you’ll reduce the likelihood of an audit.
Here at ZenBusiness, we understand that it can feel overwhelming to manage your business and all the finances that come with it. That’s why we offer all the support you’ll need to make your business successful. Whether you need help starting your first LLC for $0 or a Money app to help you streamline your expenses and deductions, we can help.
In some cases, a small business gets audited because the Internal Revenue Service notices a discrepancy between their tax form and one of their clients (or another red-flag scenario). However, the IRS also randomly selects some returns for an audit each year.
Historically, small businesses are pretty unlikely to get audited; the vast majority won’t, especially if they file their returns correctly. That said, some pros predict that business audits might become a little more common as the IRS increases their staffing. Time will tell if that changes.
If your small business gets an audit notice, don’t panic. In many cases, the audit process is as simple as reviewing your financial records, comparing them to your return, and resolving any discrepancies. If you filed through a tax preparer or a tax preparation software, odds are you’ll have some sort of guarantee that will help you with this process, too.
If your audit does result in a debt for your business taxes, the IRS does allow you to get an extension or monthly payment plan for your tax burden.
Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
Written by Team ZenBusiness
ZenBusiness has helped people start, run, and grow over 700,000 dream companies. The editorial team at ZenBusiness has over 20 years of collective small business publishing experience and is composed of business formation experts who are dedicated to empowering and educating entrepreneurs about owning a company.
Additional Resources
Business Expense Resources
Ready to Start Your LLC?
Form Your LLC Now