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How to be IRS Audit Ready as a Small Business
Worried your small business is going to be audited by the IRS? What you need to know about small business IRS audits and how good bookkeeping can help.
What's Ledger Finance?
Bookkeeping, tax prep, and financial strategy for growing small businesses.
Owning a small business is a rewarding experience, but as a small business owner you quickly learn it's not always as easy as it seems. From juggling the mundane everyday tasks to ensuring you're reporting the correct numbers on your taxes to the IRS. A business owner needs to wear many hats to be successful and prepared.
When you're your own boss, you increase your chances of being audited by the IRS. This is particularly important because in 2020, the IRS announced they would be doing a 50% ramp-up on small business audits in 2021 and beyond. An IRS audit is not the easiest process to go through, and it can be daunting to have to face on your own.
However, the reason the IRS is auditing your company isn’t a mystery. At the end of the day: they want to do one thing: verify that your tax return is valid. They do this by ensuring you have all the proper documentation for everything you’re claiming.
We're here to walk you through everything you need to know about the triggers, the process, and how you can prepare your business to be ready.
Let's take a closer look:
What is a Small Business IRS Audit?
An IRS audit is when the IRS takes a deeper look into your financial records and tax filings. They are looking to ensure and confirm the accuracy of what you reported on your annual returns. An IRS audit usually happens because their computer system found something unusual or suspicious after filing. The IRS will also sometimes audit at random, so there isn’t always a cause for alarm.
As long as you have all the documentation and receipts to support the numbers you reported, you shouldn’t have anything to worry about during an IRS Audit. Regardless, the situation can certainly be stressful for the small business to go through. So it's best to come prepared and cover all of your bases.
Common Audit Triggers for Small Businesses
Late Filing or Not Reporting
If you’re filing your taxes late every year, you’ll start to receive unwanted penalties, and it may be enough to have the IRS look into your small business. What’s worse than that is not filing your taxes at all. If you fail to report your taxable income every year, it can increase your chances of an audit. Even though mistakes happen and deadlines pass, always remember to file on time. If you’re behind contact a tax professional to help you get caught up.
Errors on Your Tax Return
There are many types of errors that can be on your tax return. Many small businesses may misreport their income by rounding up, rounding down, averaging, or forgetting to report their income completely. Try to stay as accurate as possible with everything on your tax report. If you don't have the documentation to support the numbers on your taxes, you should revise or double-check to see where you may have gone wrong.
Itemized deductions are normal for small businesses and their owners. You can claim everything from your home office, monthly internet bills, travel costs, and your vehicle. However, too many deductions can cause a trigger with the IRS especially if they are wildly out of balance with your reported income.
Whether it's an ordinary or a necessary expense, you'll want to make sure all your deductions are legitimate. When adding deductions to your tax return, save all your receipts and have everything documented and accounted for to ensure you can prove your claims.
Not all charitable donations can trigger an IRS audit, but if a company donates an outsized sum of money to a charity, it may look like they are trying to avoid paying taxes.
If your business has losses year after year, it could be considered suspicious behavior. Business losses aren’t uncommon, especially during the early years of a business. However, if you’re always claiming losses, it may ruin your credibility with the IRS.
If your business is losing money every year, you’ll want to ensure you have all of the documentation you need to support this. Always document your revenue and expenses for the year and have all the resources to back your claim available.
Large Amounts of Cash Transactions
A cash business is a business that uses cash for profit and revenue. These include hair salons, nail salons, barbershops, and some restaurants. Some businesses rely heavily on cash for profit, making them more susceptible to audits. The best way to avoid this is to verify your income and document your transactions.
How the Audit Process Works
If the IRS decides to audit your small business, you'll receive a notice in the mail. The notice will include contact information, next steps, and the documentation that the IRS would like to look over. The process will take place entirely over mail, phone, or in-person. Sometimes, an auditor will unexpectedly show up at your home or place of business to conduct the interview.
If it's an audit done by mail, you can also request to have it changed to in-person if you're more comfortable with that.
Generally, the IRS can initiate an audit within three years of your filing date. If there is a much larger issue at hand, they may choose to go as far back as six years. If the IRS suspects fraud there is no time limit to where they can go back. The law requires you to keep at least three years of financial information readily available.
Once an auditor has conducted their audit, there are three possible outcomes.
- All information you provided is correct, and your tax return won't change.
- The IRS finds a mistake, and you agree.
- The IRS finds a mistake and you disagree.
If you disagree, you have 30 days to file an appeal. If there's enough time remaining on the statute of limitations, you can also meet with your auditor to discuss your disagreements.
How to Prepare for Your Small Business IRS Audit
If your business needs to undergo an IRS audit, don’t panic. This process may seem stressful, but if you're prioritizing your bookkeeping and keeping a good, clean reconciled book: there's nothing to worry about.
Once you know you'll need to go through the auditing process, here's what you'll need to do.
Find a Tax Professional
While you can try to defend an audit alone. You’ll want to get in touch with a tax professional who can represent you through the Audit. They will be there to help you prepare for the audit and will advocate for you and your small business. Throughout the audit process, your business can lean on them for all communication and documentation that goes to the IRS.
Keep in mind: it's not your tax professional's job to find all the documentation you need. To ensure there are no unwanted delays in the process, have all of your bookkeeping, receipts, and documents on hand and ready to be sent to your tax professional.
Know Why The IRS is Auditing You
Understanding why the IRS is choosing to audit your business will help you better navigate through the process. You can figure out where you might have gone wrong and what mistake you might have made in the process so you can avoid them next year. A qualified tax or accounting professional can help you get to the bottom of this.
If the IRS decides they need to audit your small business, they mean business. So it’s best to be prepared before hand with clean books and thorough documentation. If you don’t have those ready, you’ll need to gather all of the documentation you used to support your claim. You’ll want to make sure you have all of your documents organized and saved from the year, including:
- Bank statements
- Travel and meal expenses
- Vehicle records
- Canceled checks
- Financial books
- Appointment books
These are just a few of the documents you should have ready. When the IRS notifies you, they will let you know what you need. Things to tend to go much smoother with an electronic version of all of this documentation readily available. The IRS won't come to you or your tax professional looking for a stack of papers. Electronic records are the business standard and can be easier to keep organized when done in advance. A team of experts like the ones at Ledger Financial can help make sure you’re prepared in the event of an audit and can even help represent you.
Keep all Your Receipts
Always keep records, never throw away receipts, and document everything. Even better-- keep digital records. There is a plethora of software platforms available for record keeping. A tax professional should be able to help you get setup with the tools you need to keep perfect records. You should hold onto all of your business receipts for at least three years. Even if the transaction is for a smaller dollar amount, it pays to be one step ahead.
Don't Leave any Room for Guessing
If you're unable to provide adequate documentation to back your claim, the IRS can choose to make estimated guesses about your expenses and incomes. Always make sure to dot your Is and cross your Ts.
How to Avoid an IRS Audit
Sometimes, an IRS audit isn’t avoidable. The IRS can pick your business at random, or your claims can be true even though they seem like they don't look like they are on paper.
The worst part is: An IRS audit can happen at any time. No matter the trigger or the reason, they're unpredictable, and you can't always plan or prepare for them to happen. The best thing you can do for yourself and your business is to keep clean books and your documents organized and ready to face an audit.
Stay on Top of Your Bookkeeping
Your bookkeeping is an integral part of your business structure and should be a top priority. If you don’t have all of the proper documentation to back your claims, you could run the risk of being audited and not being able to prove your claims. That means you want to keep track of everything financially for the entire year, from your income and expenses to your donations: even if it’s minor, document it anyway.
You'll also want to make sure you're prioritizing your bookkeeping all year long, not just during tax season. This way, you can see problems before they occur and look for ways to make improvements ahead of time.
Always Be Mindful with Deductions
If you choose to go above and beyond the normal deduction, you can risk getting audited by the IRS. If you decide to be more granular with your deductions you’ll want to have the proof to prove it.
Be as Specific as Possible
The more specific you are, the better. Provide the IRS with all of the information they need during tax season and be specific with the language. For example, don’t write “other expenses.” Instead, put “expenses for company travel on May 22nd.” This small change will improve your credibility and let the IRS know you aren’t creating nonexistent expenses.
An IRS tax audit is never easy. However, if you’re doing everything right and have a good, clean reconciled books: there's no need to worry.
If you're going through an IRS small business audit, lean on the team at Ledger Financial. With a tough, trained, and experienced team in your corner, you can rest assured that everything will be taken care of. We know what the IRS is looking for and can help you track your financial data and keep your records up to date. We’re here to walk you through everything you need to know to stay prepared and ready for tax season and an IRS tax audit if you need one.
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