What is an IRS Audit and How to prevent one.

Once you understand how audits work, they become more uncomfortable than scary. We’ll cover that first, then move on to ways you can avoid an audit—and how to make the process easier.

What is an audit?

When the IRS audits your business, it audits the books as a whole. This means reviewing your financial statements and making sure they match your books.

Generally, they want to make sure you don’t underreport your actual income or overstate your deductible expenses. Either way, you’re reporting less tax debt than you actually have.

What happens if you are audited?

An audit can happen in three ways:

• The Tax Office will determine that you owe them nothing and leave you alone.
• The tax office finds out that you owe them money. You sign an official document confirming the amount you owe. Then you pay.
• The IRS finds out you owe them extra tax and you deny it. In this case, you need the support and expertise of a tax attorney, registered agent, or CPA. Depending on your claim, the tax authority will either reduce the debt, force you to pay the full amount, or refuse payments altogether.

What triggers a review

A review is almost impossible to predict. But they are triggered for one of three reasons:

• Random selection by the IRS system
• Computer audit – returns outside IRS “standards” are flagged
• Related audits – if your tax return is related to another audited taxpayer, only the company can be audited.

Small Business Signals That Can Trigger an Audit

While no, there is no magic eight ball to predict audits, doing one of the following will increase your odds of getting one:

• Not reporting income that received an audit. Already reported to the IRS (W2s or 1099s). You can be charged with tax evasion
• Taking suspiciously large deductions – how to deduct 100 percent for personal use of your car. You May Be Sued For Tax Fraud
• Employee Misclassification
• Failure to File Information – W2s, 1099s, Etc.

Different Ways You Can Get Audited

In the movies, a team of IRS agents kick in your door and rob your office. Your business partner is leaving for the Caymans on a private jet. Your accountant locks himself in the bathroom. Your secretary is resigning.

The review doesn’t look like this in real life. (Although in rare cases, the IRS may conduct a field audit.)

In most cases, an audit follows one of three formats.

• Correspondence check

The Tax Office requests additional information by email or post. This is usually due to the omission of income or some other serious error. You must either pay the amount stated in the correspondence, dispute it with an attorney, and/or provide the necessary documentation, such as deduction receipts or missing W2 forms.

• Office inspection. 

The IRS may want to interview you in person. You will have to go into the IRS office. It’s wise to bring along a CPA or a lawyer. You may end up paying more in taxes or penalties, or if you dispute it, not having to do anything at all.

• Line-by-line audit.

It will be chosen randomly. The IRS examines every line on your tax return so they can establish “rules” that will trigger future audits.

Don’t worry though. As long as you comply (or legally challenge), provide sufficient evidence where necessary, pay the fines and show you had no criminal intent, you’re fine.

How Far Can the IRS Audit Go?

There is no surefire way to avoid an audit. But you can certainly reduce the chances of this happening if you do the following.

All Your Income Account

The IRS uses information from W2, 1098, and 1099 forms to compare your income and the deductions you report from income with information provided by others, such as employers, banks, and businesses. Any discrepancy between reported incomes that results in an underpayment of taxes is an obvious red flag to the IRS. This probably deserves further investigation.

So if you have a side hustle—consulting or freelancing—be sure to report the income, even if you think you can hide it.

Check your return again

Making a careless mistake on your tax return is one of the easiest ways to guarantee yourself a visit from the taxman.

If there is a deficiency, calculation error, or mistake in your declaration, the tax administrator is obliged to investigate your case in more detail. Hire an accountant to make sure your books are complete and tax-ready. Bench not only does your books, but it can also collect taxes on your account through a tax reporting service.

Be consistent with the accounting method

As a business owner, you can choose between two different accounting methods: cash or accrual accounting. If you bounce back and forth between the two methods, the IRS may think you’re trying to confuse them. Then you will be audited.

Whatever accounting method you find works best for your business, remember to be consistent.

Be Clear – Employee or Contractor

When hiring help, it is very important that you correctly classify employees as employees or independent contractors. The difference determines what taxes are due, when, and by whom.

In general, income tax must be withheld from the employee, and unemployment, social, and medical tax must be paid. With an independent contractor, you don’t have to withhold their wages or pay taxes.

What is the limitation for tax audits?

The IRS usually has three years after you file your tax return to audit you for that tax year. However, there are some exceptions.

Significantly Underreported Income

If you reported less than 25% of your gross income, the IRS has six years to audit your federal tax return. This also applies if you pay the same amount through other tax measures as if you declared 25% of your gross income.

Exclusion of Foreign Earnings

If you fail to report $5,000 or more in foreign income (such as cash held in a foreign account), the IRS statute of limitations extends up to six years.

Failure to file IRS Form 5471

If you own an interest in a foreign corporation and do not report it on Form 5471, the statute of limitations runs indefinitely. This means you may experience an IRS tax audit on every return you file.

Review Simplification

No one wants to think about the worst possible scenario. But if you take the right steps now, you can make tax audits less painful later.

Here are two things you can do to make the prospect of an audit less intimidating.

1. Organize Your Records

Keeping your small business records organized makes it faster and easier to prove that the IRS is questioning you.

One distinction that the IRS usually examines is the difference between a hobby and a business. Sometimes called the “hobby loss rule,” the IRS states that if you have an activity that is not defined as a business, “allowable deductions may not exceed the gross income of the activity.”

Using accurate accounting and financial records to prove the legality of your reported profit margin helps demonstrate that you are running a legitimate business and are not claiming tax credits for, say, your personal macramé workshop.

2. Separate Personal and Business Expenses

The IRS is strict when business owners keep separate personal and business finances. Unless your business is self-employed, you must by law manage your business and personal expenses in separate accounts.

If you mix costs, you pierce the corporate veil. This means that creditors, including the IRS, can seek your personal assets if your business is on the hook for unpaid debts.

If business and personal expenses are currently mixed in the same account, open a small business bank account and separate the expenses as soon as possible.

In addition to further legal separation of your personal and business assets, all your business expenses are held in a dedicated business bank account, making tax audits much easier.

IRS Fines and Penalties

So you messed up your tax return. Maybe it was revealed in an audit, or maybe you dropped the ball and showed up late during tax season.

Don’t worry – unless you have criminal intent, you probably won’t end up in jail or have your small business confiscated.

Here are the IRS tax penalties for the most common non-criminal offenses.

Reporting late taxes

First, you can always request a tax extension.

But if you file your taxes more than 60 days after the due date or grace period, the minimum penalty is $205, or if you owe less, 100 percent of the amount owed. However, this is only if you apply immediately after 60 days.

A penalty of 5 percent of unpaid taxes per month is added for each month of failure to report.

Even if you know you can’t pay your bill in full, you still need to file your taxes and pay what you can. The interest of the Tax Office is growing rapidly.

Payment of late taxes

You must pay an additional 0.5 percent of unpaid taxes each month until the original tax bill is paid, up to a maximum of 25 percent of the total tax bill.

Warning, this penalty also applies if you send a check on time but the check bounces.

Combined late presentation and late payment

Fortunately, these two fines do not overlap. If you miss both, you’ll only pay 5 percent monthly interest.

Paying Late Taxes After a Notice Is Issued

If the IRS determines that you owe more tax than you originally estimated, it will send a notice asking you to pay an additional fee. After that, you have 21 calendar days to pay the additional amount, otherwise, interest of 0.5 percent per month will start to accrue.

Late Form Filing

If you are late with a W2 (Employers) or 1099 (Contractors), the penalty is up to $50.

If you file Form 1065 (Partnership) or Form 1120S (S-Corps) late, the penalty is up to $195 per month per partner.

Penalties for an error

Understatement of tax liability

If you report significantly less tax than you owe or the IRS finds you tax negligent (meaning it wasn’t just a minor mistake), the penalty is a 20-40 percent increase of your tax liability.

Employee taxes are calculated incorrectly

All unpaid federal employee taxes are subject to a 100 percent penalty. In other words, you have to pay twice as much employee tax that is not paid the first time. Here are two common scenarios: employee wages are not reported through the payroll service provider and employee tip income is not reported.

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