The Internal Revenue Service (IRS) conducts business audits to check if a taxpayer’s business tax return is accurate. This process involves examining the taxpayer’s financial accounts, supporting documents, and other information to verify the reported information, such as income. The audit may result in the taxpayer owing additional taxes, penalties, and interest. Businesses can be selected for an audit randomly or due to related-party transactions or specific tax issues. Whether you’re a business owner or a freelancer, understanding the potential triggers for an IRS audit is essential to help you avoid costly mistakes and ensure your business remains compliant with tax regulations.
How does the IRS conduct audits?
The IRS employs a computer program called the Discriminant Information Function (DIF) to identify unusual tax returns. The DIF scans each tax return for anomalies in claiming tax credits or deductions that seem out of place. Tax returns with the highest DIF scores are selected for human review, which may result in a correspondence audit where the IRS requests receipts or other documentation to verify the accuracy of your tax return information. If the IRS decides to conduct a deeper investigation into your finances, you may be invited to meet them in person, either at an IRS office or your home or business. In this case, seeking representation for an office or field audit may be wise.
What triggers an IRS business audit?
Although the IRS keeps the exact method of identifying audit targets under wraps, there are some warning signs that can increase your chances of being audited. For instance, if your tax return shows any irregularities like significant cash transactions, a sudden spike or drop in income, being self-employed, or having offshore accounts, it could put you on the shortlist for an audit.
The idea of an IRS audit can be quite daunting, as it can have severe consequences for both you and your business. However, there are measures you can take to minimize the risk of an audit or lessen its impact. Here are some of the typical triggers for an IRS business audit to keep in mind.
- Using Round Numbers
It is common to round to the nearest dollar for amounts on your tax return. However, if you start rounding to the nearest hundred dollars, things start getting dicey. Those numbers look suspiciously more like estimates or guesses. Use precise numbers whenever possible, and keep detailed records of all your expenses.
- Math Errors and Typos
Another common mistake is mathematical errors, which can be caught by the IRS’s verification programs. Any discrepancies can lead to your return being flagged for further review. It’s also crucial to ensure that personal information, such as your Social Security number and address, is accurately entered. Small typos can cause significant issues, so it’s best to double-check all the information on your return.
- Large Cash Transactions
Large cash transactions can be a major red flag during business audits. The IRS is constantly vigilant for any signs of deception, and cash payments are particularly challenging to monitor compared to other payment methods. Moreover, financial institutions are obligated to notify the IRS of any significant cash deposits, which means that if you haven’t reported your cash income, the IRS may already be aware of it.
- Excessive Deductions
The IRS compares a taxpayer’s deductions to the average total deductions for a given item claimed by other taxpayers in the same income range. The IRS may further scrutinize a taxpayer whose deductions appear to exceed these averages. Taxpayers should claim every deduction they are entitled to, but they should also ensure that they have proper documentation.
Freelancers, sole proprietors, and other small business owners who are able to deduct business expenses through a Schedule C are at risk for tax audits, especially if the deductions seem abnormal when compared to similar tax returns. Comingling personal expenses and business expenses is also a common pitfall for the self-employed. Keep good records of your business expenses, and make sure you can document that the expenses are related to your business.
- Unreported Income
The IRS gets duplicates of individuals’ 1099s and cross-checks them with the figures submitted in their tax filings, utilizing automated systems. If there is any inconsistency, like a 1099 that isn’t mentioned in a tax return, it might spark an additional investigation. In case a person obtains a 1099 form that doesn’t belong to them or has inaccurate details, they ought to reach out to the sender and request them to file a revised version with the IRS.
- Claiming 100% Business Use of a Vehicle
The IRS knows that it’s rare for someone to use a vehicle they own 100% of the time for business purposes. Claiming 100% business use of a vehicle will almost certainly draw IRS attention. Taxpayers should ensure that they have detailed records to support their claims.
- Claiming Business Losses
If you keep showing losses on your tax filings for your enterprise, the IRS could decide to investigate your company because they might not believe it’s legitimate. To qualify as a business, taxpayers need to anticipate earning profits that make sense. While it’s not unusual for small businesses to incur losses, several years of losses could make them suspicious. The IRS anticipates that taxpayers will report profits for three out of every five years that they’re in operation.
- Major Changes in Income
Most people earn a relatively similar amount from year to year. However, large changes in income may indicate that someone is manipulating their reported income for a more favorable tax treatment—aka tax fraud. If you experience a significant change in income, be sure to document the reasons for the change and have evidence to support your reported income.
- Foreign Bank Accounts
Owning cash or assets in a foreign country, even if it’s all above board, could trigger an IRS audit. They don’t have jurisdiction and may not demand records from foreign institutions, and keeping assets in foreign accounts has a history of being used to evade taxes. If you have offshore accounts, make sure you properly report them on your tax return and keep detailed records of all your transactions.
- Cryptocurrency Transactions
Cryptocurrency is a relatively new form of payment that is rapidly gaining popularity. However, it’s also an area that the IRS is paying close attention to. The IRS targets Bitcoin and other virtual currencies, as people have avoided this tax liability. If you have any cryptocurrency transactions, make sure you properly report them on your tax return, even if you have realized losses.
How Far Back Can the IRS Audit?
In general, the IRS has a statute of limitations of up to three years to audit tax returns, but they can extend this period up to six years if they identify significant errors or omissions. However, in cases where a taxpayer has failed to file a tax return, the statute of limitations does not commence, and the IRS can audit their records at any time. Additionally, if the IRS has reason to believe that a taxpayer has committed fraud or evasion, they can conduct audits going back indefinitely.
How long should tax records be kept?
Since the IRS can audit the past three years’ tax returns, taxpayers should keep all tax returns and records for at least three years. Some experts recommend keeping tax returns for up to six or seven years in case the IRS goes back further than three years when conducting an audit.
What should you do if you’re audited?
If a taxpayer receives a notice from the IRS that their tax return is being audited, they should respond to all IRS requests promptly and in a friendly and cooperative manner. Often, the audit can be handled by mail, and the taxpayer may not even have to meet the auditor face to face.
Taxpayers should consider consulting with a tax professional if the IRS business audit is complex or involves significant amounts of money. If an accountant prepared the tax return, they should be involved in the audit.
Being audited by the IRS can be a daunting prospect, but there are steps you can take to avoid an audit or mitigate its impact. You can reduce the chances of having to go through an IRS business audit by keeping good records, accurately reporting all your income and deductions, and avoiding common triggers.
Navigating IRS Business Audits with Eco-Tax
At Eco-Tax, we know how stressful it can be to deal with an IRS business audit. That’s why we offer comprehensive business audit services to help you navigate the audit process with ease. Our team of tax and bookkeeping experts is here to support you and ensure that your business is compliant with all tax laws and regulations.
If you’re worried about the possibility of an audit, we can also help you set up your business to avoid them in the first place. We offer free consultations to help you understand our services and how we can assist you. Just give us a call and schedule a consultation today!
Dealing with an IRS audit can be a daunting task, but with the right support, it doesn’t have to be. Let Eco-Tax take the burden off your shoulders and help you get through it smoothly.