Fact: There is no one braver than an entrepreneur.
Okay, you could make the argument that firefighters, police officers, marines, etc. are physically tougher, and more daring, but when it comes to facing the business world head-first with a steady hand, the fearlessness found in entrepreneurs is unmatched. However, even with the guts to brave the risks associated with starting a business of their own, they still get anxiety attacks thinking about a tax audit.
The reality is that companies get audited for any number of reasons–or just out of the blue! But it’s valid to wonder what makes some businesses more likely to be audited than others?
What business owners can do to prevent an IRS audit
The following list identifies key activities the IRS actively looks for and outlines some ways your business can prevent an examination:
#1: Keep Personal and Business Expenses Separate:
The IRS aggressively enforces all business owners keep business and personal spending completely separate. While many entrepreneurs attest that there’s a level of uncertainty when drawing the line between expenses, tax law requires that business expenses must be ordinary (common and accepted in your trade or business) and necessary (helpful and appropriate for your trade or business) to be deductible.
For example: If you run a fashion blog or YouTube channel that focuses on make up tutorials, by all means, bring the receipts for your Nordstrom shopping excursions or trips to the salon to your tax expert as business expenses. But if you’re a REALTOR® claiming excessive spending on fashion and beauty purchases, your tax preparer will probably advise against claiming them, as it may raise some eyebrows (and not the way tweezing and shaping does).
That said, there are a few common areas of scrutiny where red flags occur for most business owners:
These are just a few types of expenses that can garner extra attention from the IRS.
Whatever you do claim, make sure you always document in the form of receipts or bank statements for outings; travel logs for parking, tolls, car rentals, mileage; and viable business reasoning for trips. Doing this will help you provide proof if the IRS does send you a notice asking for justification and so you can consult with tax specialist before you file.
Protip: Use our handy checklist to track which business expenses you’re claiming.
#2: Provide Proper Documentation for Tax Credits
Tax credits, the Research and Experimentation (aka R&D) Credit are great for businesses because they provide a dollar-for-dollar reduction in tax liability (as opposed to deductions which reduce liability at the taxpayer’s marginal rate). Claiming tax credits is a detailed process involving meticulous record keeping and complex calculations.
To claim a credit you’ll use the corresponding form provided by the IRS. While this may sound straightforward and the form may look pretty minimal, a lot of the work happens while the credited activity is in progress. If you’re embarking on one of the activities listed and hoping to take the tax credit, consult with a tax expert to ensure you’re complying within the set p’s and q’s.
Don’t Miscalculate Your Credits!
This is one more reason to have a certified tax professional on your side. Even if you are 100% eligible for these credits, calculating the actual reduction to your tax liability can be tricky. The IRS is used to finding errors in calculations, making them likely to scrutinize each claim even more thoroughly.
#3: File Your Payroll Tax Returns:
Employers are fiduciarily responsible for payroll tax withheld and must transmit the tax in a timely fashion. The IRS is particularly harsh in enforcing fines for late payroll tax reporting.
This means, as an employer, you must file payroll tax returns for all compensation to employees. The amount reported as your total compensation expense for income tax returns should then match the amount reported for payroll tax.
#4: Follow the Filing Rules in Every Place You Do Business
If your business has a presence (property, payroll, or sales) in a state, you should look at the filing requirements for that state. Types of state taxes may include income, sales, franchise, and gross receipts taxes, but these requirements vary by state which is why this can get tricky.
If you have an office and employees in a state, your business is likely responsible for filing income and payroll tax returns in that state. While 100% of your income is included on your federal return, if you have sales, locations, or employees in multiple states, apportionment of your income is required to determine your liability in each one.
Psst! Do you have foreign business?
If your business has foreign activities or shareholders, you should be aware of the required forms based on your type of business (forms 5471 or 5472). Failing to file or filing late can result in a $10,000 penalty per form, per year!
#5: Make Charitable Contributions in Cash Instead of Property:
Donating to charity is a socially responsible way to save on business taxes while also spreading goodwill throughout your team. In fact, so many businesses add this to their end-of-year tax saving strategy that there’s an entire day and hashtag dedicated to #GivingTuesday, the first Tuesday of December.
The IRS requires proof for most charitable donations, whether in the form of cash or property. While cash donations are easily documented by a check or receipt; non-cash items like furniture or equipment require documentation of fair market value and tax basis.
This is definitely something to consider when weighing your options for how you want to donate to your charity of choice. If you do choose to donate property instead of cash, be conservative when estimating the value of property. A two-year old computer has practically no value. As always, documentation is crucial in case of an audit!
#6: Proofread, proofread, proofread:
Watch out for wrong or missing social security numbers, math mistakes, errors in figuring credits or deductions and forms that are not signed or dated. An inadvertent error most likely won’t trigger an audit, but it will require time and effort to fix.
While that small math error or basic typo may only warrant a quick notice for correction, that can be all it takes to grab enough attention to flag your return and look for other potential areas to investigate.
Taxpayers should always keep accurate books and records, strictly segregate business and personal expenses and be sure to maintain documentation of expenses.
If your business does get audited...
Remain calm. The reality of being audited is that, it happens to the best of us and it does not need to mean the end of your business. To put yourself at ease, learn more about the different types of audits you might experience, how to get prepared (aka organized) for your audit, and what you can do if your feel that the IRS is wrong about how much you owe.
Before you cross that road, look for legitimate strategies for saving on your taxes and more importanly, best practices for making sure you take the right steps when you go to file.