Everything You Need to Know About Tax Audits

If you’ve ever worried about getting audited, you’re in the majority of small business owners. Here's what to expect if you do get audited.

Do you worry about getting audited? If you answered yes, you’re in the majority of small business owners. One of the most common questions I hear at tax time is, “What are the chances that I will get audited on my tax return?”

While it’s true that small business owners, especially self-employed individuals, have the greatest chance of being audited by the Internal Revenue Service in the US (IRS) or the Canadian Revenue Agency (CRA) — simply because their returns are more complex — it’s also true that very few businesses are actually audited.

I can’t give you a guarantee that you won’t get audited if you follow my suggestions, but I can tell you what the most common audit triggers are and how to avoid them. First, though, let’s look at what to expect if you do get audited and the three types of audits.

What to expect if you get audited

The IRS or CRA will notify you, usually by mail, if they are going to audit you. If you receive a letter, don’t panic, just begin preparing a few items. Make sure you have a copy of your tax return and gather all documents that support everything you claimed on your return. In certain cases, it may be wise to have an accountant or tax expert present at the audit, depending on which type is planned. There are three types of audits that can occur.

1. The first is a Correspondence Audit. This is the most common type of audit and usually results from a mathematical error. Every tax return is run through a systematic computer tracking system. This system will detect math errors and will check to make sure your 1099 Statement of Income or T5 Statement of Investment Income forms match the ones the IRS or CRA received from your bank or broker. Typically, if your mathematical error is made by mistake and deemed to be non-negligent, no penalty will occur. You will have to pay the difference if the error has caused your tax rate to increase.

2. The second type of audit is called a Field Audit. An IRS or CRA representative will contact you and arrange a time to come and verify your return. Typically, a field audit is done if you have too many write-offs to verify by mail. These audits are mostly targeted at small business owners, especially the ones who work out of their own homes. Since home deductions can be sizable, the IRS or CRA want to verify that you are indeed working out of your house and that your estimation is correct. This type of audit usually lasts two to four hours. The auditor will want to see all records of the expenses you claimed on your return. So make sure to gather all supporting documents and have them easily accessibly during your audit. If the auditor has found your deductions to be ineligible, you will have to pay the adjusted tax and will be liable to a penalty if the error was deemed to be negligent. If you are unfamiliar with some of the deductions claimed or tax in general, it might be wise to hire a tax expert or accountant to be present during your audit.

3. The third type of audit is a Random Audit. This is the least likely to occur, but it is also the one you’ll hope doesn’t happen to you. Every year, the CRA and IRS perform random audits for their own statistical purposes. If you are selected at random you will most certainly need a tax expert present. The auditor will meet with you in person and will perform an in-depth audit of your entire return. For every item, they will want justification or proof for why you did what you did. For example, if you claimed to be married on your return they will need to see a marriage certificate as proof. Be short and concise with your answers. The more you talk, the more potential questions the auditor may have for you. The auditor will inform you at the end if there are any taxes owing. If you want to appeal, I suggest having your tax expert handle the process.

What you can do to prevent an audit

There is no guaranteed way to prevent an audit of your tax return. However, there are ways you can reduce the chances your return gets selected by the CRA or IRS. Here are my top five suggestions for avoiding common audit triggers.

  1. Review your tax return thoroughly before you submit it, whether you prepare your own or hire an expert to file it for you. Double and triple checking can help avoid common errors that could raise a red flag. If you have prepared your own return make sure that you have someone else review it to ensure there isn’t anything you missed. If you are Canadian, you may want to have a look at this article on how to prepare corporation income tax returns in Canada.
  2. Be truthful. If you claim only what you can prove then you will have nothing to worry about during an audit. Everyone wants to minimize their taxes owing, but falsifying your return can come back to bite you. There is always a chance when submitting a tax return that you will be audited, but by following theses strategies as well as having a tax expert accountant prepare your return, you can greatly decrease your odds of an audit.
  3. It is impossible to completely reduce the possibility of being audited, but there are ways you can reduce your risk. Filing as a sole proprietorship instead of as a corporation may put you at risk of being audited, so consider the possibility of incorporating. Incorporating also has many other advantages. Check out this article on converting a sole proprietorship to a corporation to find out more.
  4. Always separate personal from business. Keeping separate records and separate bank accounts will ensure you are not mixing your income and expenses.
  5. Filing your taxes on time will also reduce your chances of being audited. Filing late will attract more attention to your return since it may have been rushed and incorrectly prepared.

Common flags that trigger an audit

Tax auditors look for red flags when reviewing returns, and these are some of the most common. Avoid these and you can help avoid an audit:

  • Consecutive years of business loss will almost certainly draw attention. Yes the IRS and CRA understand most small businesses will have losses in the first few years. But if your business continues to accumulate losses, the IRS or CRA will start to assume you are sheltering profits. The chances that a business is still around after five years of consecutive losses is hard to imagine, which is why such a business is likely to get audited. If you are still facing such losses after that many years, it may be time to consider something else or maybe you just need to reduce your taxes. Take a look at this article on tax reduction for the self-employed in Canada.
  • High expense claims is another red flag. They will compare your expenses to other relative competitors in your sector. If your expenses are materially above your competitors, you will most surely be audited.
  • They will also take a close look at home office and motor vehicle expenses. These expenses can be manipulated in your favor fairly easily since they are based on estimations. This is why the IRS and CRA will spend more resources auditing theses specific areas of your business return.
  • Large charitable donations are also a common trigger. Very few people or businesses give 30% of their income to charity.

The most effective way to reduce your audit chances is to have your return filed by an accountant or tax expert. They are trained in understanding the law and will be your best bet in avoiding a tax audit.
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