Small business guide: How to avoid an IRS audit

There’s a TV commercial I remember from a couple years back: a man is being audited by the IRS. He drags a huge trash bag full of unorganized receipts down to the local IRS office and tries to explain his taxes. The IRS agent quiets him down and asks, “Did you make money last year?” The guy nods. “Did you give most of it to use?” The guy nods. That’s the entirety of the audit.

For small business owners, IRS audits are one of the scariest experiences out there. They eat up time and money. But how can we avoid them?

There are two types of audits, and one is out of our hands. The IRS does chose to do random audits, and there is little that can be done about those, except making sure your paperwork is in order. However, you can cut down on the likeliness of the IRS choosing your business to audit because of an issue they see with your taxes.

First off, make a list of everywhere you receive income from. The IRS automatically receives copies of every W-2 and 1099 and if you fail to list any income, they will definitely be knocking on your door. Double check your tax returns. Heck, triple check them to make sure you haven’t omitted any income.

Second, go electronic. There are plenty of relatively cheap software packages that are well worth the investment. Computers keep track of the details, like making sure all the correct pages get signed, and will make sure there’s no sloppy math errors. The first batch of tax returns the IRS audits is always the incompletes or the erroneous.

Third, even though common wisdom says to keep your tax returns for only three years, it is worthwhile to hold on to those older tax returns, as well as proof of mailing. The IRS, if they suspect fraud or believe that you never filed a return, is allowed to investigate as far back as they want. Being able to pull out an old tax return can be the difference between a lengthy audit and a few quick calls.

Here are a few red flags the IRS looks for:

• Self-employed – The IRS says most people who cheat on their taxes are self-employed. It’s not an automatic tip off, but be aware that you are more likely to get audited. Within this category, they especially scrutinize deductions for home offices and large entertainment expenses.
• Payroll taxes – If you do have employees, the IRS will check to make sure federal payroll taxes are being deposited. Make this a priority, because if you do get audited, a screw up here will have substantial penalties.
• Cash-based businesses – The IRS suspects all cash-based businesses, because it is so much easier to avoid reporting cash income. Cash-based businesses are far more likely to be audited, and there is a special form for large cash transactions (Form 8300 for transactions over $10,000). A number of state tax agencies will also insist on special forms and extra scrutiny.

And remember, if you do get audited, and the IRS finds problems with your paperwork, you are more likely to get audited again next year. Treat it as an opportunity to clean up your act.