Paying taxes are tough enough for any business owner; but more so when you are summoned by the tax man to be audited. Receiving the tax audit letter is very nerve wracking – and with good reason. The key is to remember that the IRS is watching, and is already aware of most shenanigans of entrepreneurs to try to circumvent the tax rules and regulations.
How do you avoid a tax audit? Be honest, keep good records and try in good faith to follow the rules. You may still be audited, and even owe a bit more, but the odds are you won’t be left imprisoned or impoverished.
Red Flags for a Tax Audit
The IRS is often on the lookout for personal expenses being reported as a business expense. The IRS provides broad guidelines on what it deems as “ordinary and necessary” business expenses, and some entrepreneurs push the envelope on what qualifies as a business expense. As such, the IRS has been very vigilant with regards to personal deductions claimed as business expenses.
- Substantial business meal and entertainment deductions
- Large questionable expenses (e.g. daycare business owner leasing a private plane to a resort island)
- Business payments made to relatives
Some other red flags for audit are as follows:
- Excessively high incomes compared to the previous years
- Large deduction relative to income
- Excessive home office deductions
- Losses form a hobby rather than a business venture
- Low incomes, but significant business deductions
- Non-cash charitable deductions
In general, red flags are assigned to any aspect of your tax forms that seems inconsistent with other reported figures. So, if you donated 75% of your net income to charity or work from home, but have generous travel deductions, it will catch someone’s attention.
Discrepancies between different tax forms are big red flags. For, instance if you’re a freelance writer or accrued interest on a bank account, you should receive a Form 1099 information return documenting how much you earned. You are assured some contact with the IRS if the tax return doesn’t accurately reflect the information returns on file with the IRS.
Tax Audit Tips
If there is a golden rule for audit, it is to not offer more information–spoken or written–then is absolutely necessary. Don’t give the auditor any reason to expand the audit.
- Don’t ignore the notice!
- Organize your records.
- Don’t volunteer information unless you are asked.
- Making the auditor’s job easier may help the process go more quickly and will help create the impression that you are an organized person.
- Replace missing records. If you can’t obtain a duplicate copy of a missing record look for other ways to support your deduction. Diaries, logs, and other contemporaneous records may help support your claim
- Provide only copies. If you bring original records, do not give them to the agent. Allow the agent to make copies but make sure you retain the originals. You must be careful because the IRS isn’t responsible for lost documents.
- Know your rights as a taxpayer!!
Recommended Books on How to Avoid Tax Audit:
- Surviving an IRS Tax Audit
- The IRS Problem Solver: From Audits to Assessments–How to Solve Your Tax Problems and Keep the IRS Off Your Back Forever
- The Eightfold Path to Pay Less Tax and Avoid an Audit
- Deduct It! Lower Your Small Business Taxes
- Tax Savvy for Small Business
- Small Business Taxes Made Easy, Second Edition