You can lower your odds of a tax audit by taking certain steps with your tax return and avoiding others – you just need to be “DIF” score savvy. DIF stands for “discriminate information function,” a program the IRS uses to determine if your small business-related tax return is ripe for an audit. While DIF details are secret, the steps below can help you reduce your odds of being audited. Each choice you make (how to file, when to file, what deductions to claim) has an impact on your audit odds. Here are 19 things you can do to avoid a business tax audit:
Be accurate. thorough and neat. Sloppy returns and math errors raise flags. Using tax preparation software makes your return look more professional and helps you avoid mistakes. Accuracy starts with keeping good records; if the IRS ever questions anything on your return, the burden is on you to prove it’s right. If your records are sloppy, it will be difficult.
Refrain from rounding numbers. Calculating your income and losses with only rounded numbers could make the process easier for you in the moment, but any inconsistencies in the money you’re being taxed on will immediately stand out as a red flag for an IRS auditor. Cutting corners here could cause you issues later.
Explain yourself clearly. Avoid vague business expense categories such as the infamous category some business owners use called “miscellaneous.” If your business is claiming unusual deductions of some kind – anything an IRS reviewer might not have come across a thousand times before – provide an explanation or documentation.
File electronically. Electronic tax return filings are convenient and, in some cases, even required. Electronic filing gives IRS fast access to 100% of your return and in nearly every instance, online tax-filing solutions have ways to check your information for errors. By using the built-in tools, you can ensure that your data is accurate. Many solutions like TurboTax offer an audit protection guarantee in which you will receive representation (or defense services) should an audit be initiated against you.
Make your estimated tax payments, and issue 1099 and W2 forms on time. Late quarterly estimated payments, nonpayments and underestimated amounts draw the ire of the IRS. Know the deadlines and meet them. File 1099s and W-2s using easy online tax services.
File on time. It’s easy to file for an extension, so there’s little reason to miss the initial deadline. Just remember that any money you owe is still due by the original filing deadline; the extra time is for doing the paperwork.
Beware of your income-to-deduction ratio. Your tax-audit odds for a small business rise if the difference between expenses and income exceeds 52%. Total deductions are only part of it. One especially large deduction can also raise flags, even if others are small or in line with other businesses in your industry.
Be wary of taking a home-office deduction. Tax returns that include a deduction for a home office are a prime IRS target, so if you plan to take a home office tax deduction, make sure you know the rules. A home office must be a completely separate room or area used exclusively for business. Here again, a CPA can be invaluable in helping you do it right, or perhaps decide if the benefits aren’t worth the hassle.
Make sure you only write off eligible travel and meals. With the passage of the Taxes and Jobs Act of 2017, businesses are only allowed to deduct 50% of their meals and travel expenses conducted for a business.
Watch those startup cost deductions. Many startup entrepreneurs and new business owners assume that money they’ve spent to get the business up and running can be deducted immediately. That’s not always the case, though; many startup costs must be depreciated over time.
Don’t mix personal and business deductions. The IRS is on the lookout for small business owners who try to deduct travel, entertainment or other costs (cell phones, merchandise, etc.) that are personal and not business-related. Remember that only business-related expenses can be deducted. Make sure you understand the rules on what portion of business entertainment costs are allowable as a deduction. And avoiding taking mileage deductions for personal use of a vehicle – that’s another IRS audit hotspot.
Make your hobby a true business. If the business you are claiming all those deductions for looks more like a hobby to the IRS, you could trigger an audit and end up owing back taxes. A real business has revenues at least some of the time and looks, acts, and spends like a business as well.
Reconsider your business structure. Owners of a sole proprietorship who file a Schedule C for each business get audited the most. To avoid the higher risk of sole proprietor audits, consider making your business a corporation or limited liability company.
Hire Best Tax + Accounting. Tax rules that affect small businesses are impossibly complex, far-reaching and downright confusing. Even for relatively straightforward situations, getting professional tax preparation advice can be a huge help in avoiding audit triggers for your particular case or industry. We do tax and accounting work for out-of-state clients, virtually.
Avoid the independent contractor trap. Another favorite IRS is misclassified workers. If your business uses freelancers and other types of independent contractors, make certain they qualify for independent contractor status. Otherwise, the IRS may determine they are employees and stick you with a big bill for back payroll taxes plus penalties.
Don’t “forget” to report income. The one thing the IRS hates above all else is unreported income. And don’t kid yourself – the tax agencies are far more sophisticated about tracing money than they’ve ever been. The IRS has extensive data on typical income levels and deductions for every type of business that exists. If yours is out of line with others like you, an IRS tax audit could ensue.
Report barter and auction income. The fair market value you receive through business barter transactions may indeed be taxable, even if you did not receive cash. Likewise, taxable income generated from selling items via online auction websites needs to be included in your return.
Avoid overpaying your shareholders. If your business is run through a group of shareholders, make sure you’re not paying those individuals an excessively high wage. That will raise major red flags for an IRS auditor, since that can be seen as an underhanded way to lower taxes by undercutting profits.
Be honest. Every year, the IRS gets better at using high-tech means to track your business income. Some things are just obvious. If you claim lots of expenses but show little revenue to pay for them, the tax folks get curious.