5 Common Causes for a Small Business Audit
Are you a small business owner concerned about getting audited?
Only 2.5% of small business owners receive the dreaded tax audit, and that number has been trending downward in recent years. Even better, with a few tips, you can steer clear of the most common red flags which trigger a business audit from the IRS.
We've compiled a list of the 5 most common causes for a small business audit.
So, if you ready, let's dive in, so you can get back to running your business with the best possible chance of avoiding an audit.
5 Most Common Red Flags for A Small Business Audit
While no one is completely safe from an audit, you can generally steer clear of tax troubles by avoiding these 5 no-nos.
Remember, you want to stay below the radar. By throwing up the red flags below, you're basically screaming "FIRE" to the IRS.
1. Your Information Trips the IRS Computer
Did you know the IRS has a sophisticated computer system whose sole purpose is to find anomalies in tax returns?
The system is called Discriminant Information Function, or DIF.
DIF scans every tax return looking for general mistakes as well as deductions and credits that don't add up.
What's important to remember is that DIF compares your tax return against others with similar earnings and professional backgrounds.
So if you're a realtor claiming $30,000 a year for gas expenses, that may not jive against what your peers have claimed and DIF will likely flag you.
At that point, your tax return is submitted for review by a human.
That's no good.
Keep it simple. Keep accurate records of your income and expenses and submit your taxes accordingly to stay in the clear.
2. Underreported Income
If for any reason, you fail to report taxable income, you could face scrutiny from the IRS.
Like individual taxpayers, small businesses are required to report all income earned in the United States.
This includes investment dividends, offshore bank interest, freelance earnings over $600, and any cash payments you've received.
Remember DIF? Well, it also checks for mistakes in income reporting to make sure your records align with those who have paid you.
If they detect an error in your income calculations, the odds you get audited rise dramatically.
One of the simplest things you can do to protect yourself is to use a dedicated business bank account and credit cards for all your company deposits and purchases.
It will help keep your business finances more organized and cleaner, with less chance for a reporting error.
3. Claiming Too Many Deductions
Claiming too many deductions is one of the most common ways to trigger a business audit. This is especially true for travel and meal deductions.
The IRS has set guidelines for your contributions and deductions according to your income level. If you're inflating your figures, even if it's unintentional, it's likely to throw up a red flag.
Example: The IRS guidelines allow for about $3,100 in contributions if you earn between $50,000 and $100,000.
So if your small business earnings fall in that range, and you claim $10,000 in charitable contributions, your business may be in for an audit.
If you're unsure of the guidelines, consult a qualified CPA to file your tax return correctly.
4. Filing Late
If you wish to avoid a small business audit, it makes sense stay off the radar of the IRS, wouldn't you agree?
Filing your taxes late accomplishes the exact opposite effect. It brings unwanted attention to your return, along with penalties and interest fees.
Get your records in order in January, file early, and enjoy the peace of mind.
5. Claiming Losses For A Hobby
The IRS allows for a multitude of deductions for you to run your small business.
But, they do not allow any tax breaks for your hobbies.
How does the IRS determine what is a business and what is a hobby?
If you claim a loss three out of five years, then according to the IRS, your enterprise is a hobby. In that case, you can only claim losses up to the amount of earned income, along with other restrictions.
Note: Sole proprietors should be especially cautious with their tax reporting because the IRS is very likely to perform a business audit.
You should only claim losses if you are extremely detailed with your records and receipts and can prove all the deductions you claim.
Keep detailed records and make sure they are reflected accurately in your tax forms to avoid a business audit.
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