Five Types Of IRS Tax Audits And How A Small Business Owner Can Avoid Or Beat Them
A small business owner has enough to worry about, without the stress of an IRS audit. Avoiding an audit is simple when you understand how the IRS chooses which business returns to select. Beating that audit is already easier. Let’s start with a look at who’s on the top of the IRS audit hit list.
The Hobby Audit
Those businesses most likely to be audited by the IRS are individuals trying to make a living doing what others do for fun. This includes people who work with horses or dogs, paint pictures, write books, gamble, play music, fish, or sell handcrafted items.
Fail this audit and your deductions will be severely limited. If you work in one of these industries you should document everything you did to produce income and function in a business-like manner. Operating in a business-like manner includes regular bookkeeping, writing a business plan, actively seeking sales or work, tracking sales efforts, and making adjustments to increase profit.
The Repeated Loss Audit
Any small business that fails to show a profit three years in a row may get a second look from the IRS; show a loss for a longer period and your business return could be audited. Beating this one requires you to prove that you are profit minded.
Proving that you are profit minded is also done by showing that you function like a business. Bookkeeping records, a copy of your business plan, a list of activities scheduled to increase sales, and proof that you made changes to increase profits will be necessary to beat this audit. Taking business and marketing classes also shows that you are trying to increase profit.
The Outrageous Deduction Audit
Inflated mileage deductions, as a hobby vehicles, vacations written off as business trips, a television for the home office, and other outrageous purchases draw IRS audits like the porch light draws bugs. Buying an RV to carry you and your pet to dog shows, writing off a trip to Europe because you also did some business, bogus mileage, and electronic equipment for your home will all fail this audit.
A good rule of thumb is… if you don’t want to see your neighbor use his tax-funded welfare check to buy it, then the IRS and honest business people don’t want to see you buy it with phony deductions, causing them to pay higher taxes while you avoid paying yours. Honesty and proper record keeping is the meaningful to avoiding and beating this audit.
The Document Matching Audit
When the IRS totals up all 1099’s received in your name and/or tax id number, if that total is less than the business income reported on your tax return you will receive a letter.
Most businesses truly earn more income than the total of all 1099’s received because small jobs do not necessarily cause 1099’s to be issued. You are required to report all income received, not just all income reported on a 1099. Falsifying your income will make you fail this audit, already if your reported income matches the total of all 1099’s.
Depositing all business income into a bank account reserved exclusively for business funds is the best way to document your income. Then, at the end of the tax year you simply compare the total income deposited with the total of all 1099’s received. If the 1099 total is bigger than your deposits you will need to figure out who reported your income wrong, and ask for a re-issued 1099 before filing your taxes. Otherwise the IRS will assume you received that money. The proper amount to report is your total income.
The Random Audit
This audit is just plain bad luck. Someone had to be audited and your return hit the desk. And when it did, an IRS employee spotted a “possible lie” on your return. It could be a travel deduction that is bigger than industry standards, tip totals smaller than others in your profession, a new computer purchased in December, or mileage figures that don’t seem right. Proof trumps this audit.
To sum it up, proper record keeping is the answer every time. If you keep every receipt, document all mileage, use a business bank account, function like a business, and hire a tax specialized to attend the audit in your place, you should beat any audit thrown at you.