At CMP, we understand the desire to avoid tax audits since they can delay your business plans or potentially drag on for months. An audit can also interfere with mergers, acquisitions or outside investments.
Unfortunately, you can never completely eliminate the chances of getting audited. Each year, the IRS uses random selection to pull a number of returns to examine more closely. The rest of the audits result from issues with the tax returns that are filed.
There are certain triggers that increase the likelihood of getting audited. In fact, there are dozens of warning signs that the IRS pays attention. So, to help your business avoid getting audited by the IRS, we’ll cover the 6 most common tax audit triggers.
1. Consistently Filing Your Tax Returns Late
When you consistently file your tax returns after their due date, you trigger penalties and interest. This can also bring more attention to your tax return, increasing the potential for an audit. Each time that you file late, you increase your risk of an audit.
How can you avoid this problem? If you regularly file late, you should start planning in advance. Get started on your returns before the end of the year.
At CMP, we offer proactive income tax planning. We typically begin the tax planning process in the fall in preparation for the April deadline.
Another option for avoiding late tax returns is to request an extension. Requesting this extension does not increase your risk of an audit.
However, even with an extension, you must file a tax estimate. This estimate must be completed and sent to the IRS before the due date for the tax return; otherwise, the extension will not be valid.
Similar to filing late, some businesses may not pay their full return. If you do not have the funds to pay your taxes, you must file an installment agreement request with your return.
Without this written explanation of the reason for your failure to pay the total amount owed, the IRS is likely to perform an audit. You cannot simply send in a lesser amount without providing the proper documentation. If you require this payment extension, you may be able to create a payment plan to cover the remaining balance due.
2. Errors in Your Tax Return Can Lead to an Audit
Errors are another common red flag that will trigger an audit. At the top of the list of errors is math errors. Errors in the calculations of your taxes can result in under or overpayment. This is one of the most common audit triggers and one of the easiest to avoid. Here’s a look at the most frequent tax return errors:
- Math mistakes
- Filing status errors
- Filing the wrong forms
- Not signing the forms
- Incorrect bank account numbers
- Incorrect names or business information
When you work with certified tax professionals, the chances of math errors and audits are decreased. When you use an experienced tax team to complete your business tax returns, they will ensure the accuracy of the returns using the latest software.
3. Reporting a Net Loss for Consecutive Years
When your business struggles to maintain a profit, your chances of getting audited can increase. We’ve found that when a business reports a net loss 3 out of 5 years, they are more likely to get audited.
Unfortunately, this situation is not easily avoided even though it is an issue related to your business operations and not your tax reporting. However you can prepare for the audit in advance.
If you know that you’re going to report a net loss for the third year out of the last five, then you should prepare for an IRS audit. This includes following the guidelines for properly reporting your business expenses.
During an audit, the IRS will review all of your documentation. Inaccurate reporting of your business expenses could result in penalties or fines. And these inaccuracies are another potential trigger for an audit.
4. Inaccurately Reporting Your Business Expenses
If the IRS suspects that you’ve filed excessive deductions for business expenses, you could get audited. Excessive deductions are a potential red flag.
Again, if you have business expenses that you want to be deducted from what you owe the government, you need documentation to back up your claims.
Make sure that you maintain receipts for all of these expenses. If you get audited, the IRS will examine your receipts and records. Do not overstate any of the expenses that you want to claim.
In addition to excessive business expenses, unnecessary deductions can trigger an audit. For example, claiming 100% of a vehicle for business use for your sole vehicle could raise a red flag.
The same is true of other major equipment. Do not claim anything as being used solely for business unless it is 100% used for business purposes.
Another area related to expenses is the Miscellaneous Expense category. The IRS always examines this category carefully. It is a catch all category that covers anything that does not fall into one of the other categories.
When the miscellaneous expense category contains an excessively high amount, the IRS is likely to hold the return for review and potentially trigger an audit. This also applies to the “office expense” category.
5. Paying Unreasonably High Salaries to Shareholders
The IRS can also look at the salary of shareholders. When they detect large salaries for shareholders who are also employees, they may want to take a closer look at your return.
Businesses with shareholders that are also employees should always carefully determine a reasonable salary. Consider the type of business that you operate, your industry, and the skill set of the employee.
Along with a salary that is too high, the IRS will look for salaries that are too low. This applies to S-Corporations. With S-Corporations, shareholders can take profit distributions without incurring double-taxation. The IRS wants to prevent shareholder-employees from taking a low salary and high distributions as a method of avoiding payroll taxes.
6. Operating a Cash-Intensive Business
Businesses that are mostly cash based will be under increased scrutiny. For example, restaurants, car washes, barber shops, and beauty salons are more likely to get audited when they underreport their taxable income. These businesses often have the most complicated recordkeeping requirements as well, due to the nature of their businesses.
If you operate a cash-heavy business, be sure to keep your receipts and POS reports organized throughout the year. In case of an audit, proper preparation will ensure that it goes quickly and smoothly.
Additional Information About IRS Tax Audits
As mentioned, audits are conducted for one of two reasons. They are conducted randomly or due to an issue that an IRS employee finds on your return. While you cannot completely avoid being randomly selected for an audit, you can avoid the errors and issues that trigger an audit.
When the IRS decides that an audit is necessary, they will contact you via mail. The process will then be completed by mail or through an in-person interview. If the audit is conducted by mail, you will need to send records and files directly to the IRS.
With an in-person interview, the interview may be conducted at your place of business or at a local IRS field office.
If you do get audited, the IRS will provide a list of exactly which documents they require. This could include any records related to your reported income, expenses, and deductions.
While conducting an audit, the IRS may look at past returns. Generally, they will not look back more than the last 6years of returns. Though, it is more common that they look at the most current 2 years of returns.
The length of the audit process will vary. This depends on the number of errors or issues that they want to examine, as well as the complexity of the situation. Your ability to provide proper documentation can also impact the length of time it takes to complete the audit.
It’s also important for you to know that you have rights as a taxpayer during this process. You have the right to representation. At CMP, we can help prepare audited financial statements. We can even perform audits of your return before filing, to ensure the accuracy of your return.
In conclusion, the best way to avoid an audit is to file your taxes properly. They need to be accurate and filed on time. Though, even by taking the proper steps, you can still get audited. It is something that most businesses will go through at least once.
When you get audited, you shouldn’t panic. It doesn’t mean that you are guilty of any wrongdoing. Instead, it is simply a way to ensure that everyone is on the same page. The government does not want you to get away with earning unreported income.
Tax returns should not be taken lightly. Again, we recommend that you remain organized throughout the year and begin planning your tax return several months in advance. You should give yourself the time to double and triple-check all the details of your return.
Don’t file your tax returns late. If you anticipate that your return will be late, you need to request an extension. Also, make sure that your business expenses are correctly reported. This includes the deduction of automobile expenses for vehicles that are owned by the business.
By taking these steps, you can reduce your chances of getting audited. Taking a proactive approach is always the best solution.
Keep in mind that this article only covers 6 of the most common red flags for an IRS audit. There are dozens of other issues that can lead to an audit.
If you’ve been audited in the past due to a different reason, please share your experience. Leave a comment in the comment section below.