Many of the small business owners would love to take precautionary steps to avoid tax audit rather than living in fear all the time. There are several reasons why IRS can audit one company instead of another one. Some of them are more complicated than you think, some of them can be easily fixed. Let's look closer at the most common triggers for a small - business tax audit. IRS uses the specific software (Discriminate Function System) to analyze returns and flag them if something is outside of the “norm.” Here are 8 red flags of this program which you should pay attention before filing your taxes:
1.Have a higher or lower income/expenses than industry average
The IRS has a listing of average income and expenses for each industry classification. If your expenses are much higher than the industry average, it is a red flag for IRS. You have nothing to worry about if you have a legit proof of it.
2.Deductions are out of proportions
All we know that tax deductions reduce our income and we would love to use as much as we can. If these deductions are out of proportion, it can trigger the system and raise the red flag. The IRS uses several tables to determine how much deductions can be too much for different income brackets.These tables are not open for public. It does not mean that you have to be scared to take the deductions that you are entitled, just keep in mind that you should have detailed records to back them up.
3.Home office deduction
This deduction can trigger the tax audit even if you are entitled to have it. The reason behind it is that many small businesses have been abusing this deduction for years. During the past years, the IRS introduced the simplified method of deducting a home office (Qualified for a home office deduction? That is how you calculate it), but it does not mean that every person who does business from home can claim it.
You still have to qualify to claim it. We already discussed it in When can you claim the home office deduction?
4.Numbers on your tax return are rounded or averaged
NEVER round your numbers! Round numbers show to the IRS that you just have estimates and did not keep a good record through the year. You do not need to include cents because they are immaterial, but you have to use closes actual dollar amounts on your tax return. For example, if you made $55,003.47 you should report $55,003.00 not $55,000.
5. Filing a Schedule C
Statistically, IRS pays 10 times more attention to schedule C than to corporate tax returns. The reason behind it that the schedule C is used by small business owners to claim the deductions that will lower their taxable income. Do not be scared to claim the legal deductions, but make sure that you have all documents to justify all of them. To avoid this red flag, many small businesses move from the self-empowerment to setting up their business as a separate entity.
6.Deductions for Business Entertainment
You already know that filing a schedule C brings extra attention to your tax return. Meals & Entertainment is another red flag. Historically, many business owners abused it by using the business money for taking friends and families to nice vacations and restaurants.
7. Claiming your vehicle almost 100% of business use
If you have a car which is used only for your business needs, you can ignore this red flag. However, many entrepreneurs use personal vehicle for business. Unfortunately, listing a personal vehicle on your business tax returns brings the close attention of IRS.
8. Claiming Business Losses Year After Year
IRS keeps records for decades in the system, and they will notice if you keep claiming the business loss for years. This can starts the auditing process of your books. It is fine to claim the loss at the moment of starting the business because setting up the company is the costly process. As long as you keep your startup costs recorded correctly, they will have no questions for you. However, you are claiming losses year after year, they may assume that you're writing off more than you supposed to.
The last suggestion for you to avoid the tax audit: get a bookkeeper how works close with CPA. They will help you to prevent this problem.