Everything You Need to Know About Tax Audits in the U.S.
January 29, 2015
Do you worry about tax audits? If you answered yes, you’re in the majority of small business owners (and humans for that matter). One of the most common questions heard 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 (IRS)—simply because their returns are more complex—it’s also true that very few businesses are actually audited.
No one can give you a guarantee that you won’t get audited if you follow these suggestions, but we 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 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.
- 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 matches the one the IRS received. Typically, if your mathematical error is made by mistake and deemed to be non-negligent, no penalty will occur. However, you will have to pay the difference if the error has caused your tax rate to increase.
- The second type of audit is called a Field Audit. An IRS 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 expenses 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 sizeable, the IRS will want to verify that you are indeed working out of your house and that your estimation is correct. This type of audit usually lasts 2-5 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 accessible during your audit. If the auditor has found that your deductions do not qualify, you will have to pay the adjusted tax and will be liable for a penalty if the error was deemed to be negligent. If you are unfamiliar with some of the deductions claimed, or taxes in general, it might be wise to hire a tax expert or accountant to be present during your audit.
- 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 IRS performs random audits for their own statistical purposes. If you’re 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 of 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. At the end of the process, the auditor will inform you if there are any taxes owing.
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 IRS. Here are the top five suggestions for avoiding common audit triggers.
- 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 information 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.
- 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 haunt you. There is always a chance when submitting a tax return that you will be audited, but by following these strategies as well as having a tax expert accountant prepare your return, you can greatly decrease your odds of an audit.
- Filing as a sole proprietorship instead of as a corporation may put you at risk of being audited. Although incorporating isn’t right for every business, it may be worth exploring.
- Always separate personal data from business. Keeping separate records and separate bank accounts will ensure you’re not mixing your income and expenses.
- 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 ones to avoid:
- Consecutive years of business loss will almost certainly draw attention. Yes the IRS understands most small businesses will have losses in the first few years. But if your business continues to accumulate losses, the IRS 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.
- High expense claims is another red flag. They will compare your expenses to other relative competitors in your sector. If your expenses are much higher than your competitors, you will most surely be audited.
- The IRS 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 they 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 chances of an audit 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. Not sure where to find one? Thousands of FreshBooks certified accountants and bookkeepers are just a click away on the FreshMap. Find one that’s in your area today, and sleep a little easier at night knowing you’re in good hands.