When starting your own small business you may attract all kinds of new attention. Your business may be featured in the newspaper, customers may be flocking to your storefront, and other business owners will contact you to do business with them. Oh, and you are three times more likely than an individual taxpayer to get a knock on your door from the IRS demanding an audit of your business. What is an IRS audit, what do the auditors look for and how can you prepare for it? These are questions that every small business owner should be prepared to ask and answer. Here is some advice on dealing with an IRS audit.
What is an audit?
An IRS audit is an examination of a business’ accounts and financial records to ensure that their tax information is being recorded in accordance with the law and to verify the amount being reported is accurate. As stated above, small business owners are three times more likely than an individual to be audited by the IRS, so be on the lookout.
How does the IRS decide to perform an audit?
The IRS assigns a score to tax returns known as a discriminant index function (DIF). The formula is kept secret, but certain things can affect it and trigger an audit. For example if a business’ deductions are greater than its reported income it may score higher on the DIF. Also, the IRS will match an individual’s tax return to the amount of income on a W-2 or 1099 to ensure income is being reported. The IRS is tricky, so fly straight and narrow in order to avoid being picked for an audit.[1]
What do IRS auditors look for?
If you are one of the lucky ones to get selected the IRS will look over you records and try to decide if:
You failed to report all of your business sales or receipts
Skimmed cash from the business
Wrote off personal living costs as business expenses
Failed to file payroll tax returns on time
Improperly classified some workers as independent contractors rather than as employees
This is not a complete list, but it is some of the things the IRS is likely to examine.
How can I prepare for an audit?
Review the tax return being audited
Make sure you can explain how you came up with your figures
Identify areas where the IRS may find problems
Find all the documents and records you need to back up your claims and organize them neatly
Neatness can add to your credibility, so be sure to be organized and ready for the agent
If records are missing, prepare an oral explanation
Conclusion
If you are a small business owner, you have a good chance of being audited at some point in your career. The IRS uses a formula to decide which businesses should be audited, so keep your tax returns honest and clear. If you are audited, prepare all the necessary documents and be ready to explain how you came up with your numbers. An IRS audit can be nerve-wracking, and you may end up owing money, but being prepared and knowledgeable can go a long way towards making your audit go smooth. Contact a tax attorney for advanced help in preparing for an audit.[2]
[1] Kemberley Washington, 4 Ways to Beat Small-Business Tax Audit, Bankrate.com (2014) http://www.bankrate.com/finance/taxes/beat-small-business-tax-audit-1.aspx
[2] Fred S. Steingold, Legal Guide for Starting and Running a Small Business 139-141 (Betsy Simmons ed., Nolo 10th ed. 2008).
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