Six Audit Red Flags and How to Avoid Them

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Lindsay Angus for Bench writes: Being the subject of an IRS audit can be stressful, time-consuming, and potentially very expensive. While there is no foolproof way to avoid an audit, there are measures you can take to drastically reduce your chances of showing up on the IRS radar. Here are six measures that you can incorporate into your business habits today to lower your chances of receiving an unwelcome visit from the IRS:

Account For All of Your Income

Are you currently a small business owner but also doing some consulting on the side? If so, be sure to accurately report all of the money you are bringing in across your different income streams.The IRS uses the information on Forms W-2, 1098, and 1099 to compare the income and deductions you report on your return with the information reported by others, such as employers, banks, and businesses. Any discrepancies between reported income amounts is an obvious red flag for the IRS and will likely provoke further investigation.

Double Check Your Return

Making a careless error on your tax return is the easiest way to guarantee yourself a visit from the tax man. In the event of any omission, miscalculation, or error on your return, the IRS is obligated to further investigate your case. Accordingly, you can greatly reduce your chances of an audit by ensuring that all sections are correctly signed, sealed, and delivered. For business returns, acquiring outside help may be a good choice.

Maintain Organized Records

Keeping organized records makes for a much smoother tax season, reduces your chances of receiving an audit, and helps you substantiate your claims in the event that you are audited. One distinction that the IRS upholds is the difference between a hobby and a business. Sometimes referred to as the ‘hobby-loss rule,’ the IRS states that if you have an activity that is not designated as a business, then the “allowable deductions cannot exceed the gross receipts for the activity.” Keeping accurate books and using financial records to improve your profit margin will help convince the IRS that you are running a legitimate business and not a claiming deductions on a hobby. Also, if you do get audited in the future, you will have unflappable records to prove where the money was coming from and going to.

Separate Your Personal and Business Expenses

The IRS is very strict about business owners keeping personal and professional expenses separate. They define a business expense as something that is “both ordinary and necessary.” Some expenses can be hard to differentiate on a receipt or bank statement, but having an account or card that is solely used for your business, as well as keeping thorough notes of why this purchase benefited your business, will make an audit less likely and also safeguard you if you’re audited in the future.

Stay Consistent with Your Accounting Methods

As a business owner, you have the choice of two different accounting methods: cash or accrual accounting. Bouncing back and forth between the two can be seen as potentially deceitful and will likely incite further investigation. Whatever method you deem best for your business, just be sure to stay consistent; failing to do so will attract the IRS to your return and potentially make you the subject of an unwanted audit. Learn more about cash vs. accrual accounting here.

Keep it Straight - Employee or Contractor

Properly classifying workers is crucial because it determines the taxes that need to be paid, when they are paid, and who pays them. Generally, for an employee you must withhold income taxes and pay unemployment, Social Security, and Medicare taxes. With an independent contractor, you generally don’t need to withhold or pay taxes on their paychecks. The IRS is on the lookout for businesses who intentionally miscategorize employees (therefore skipping the taxes). If you frequently work with full-time independent contractors, be sure that they really are contractors and not employees. If you’re not sure whether you are working with an employee or an independent contractor, learn more about How to classify your team.

No one wants to be questioned by the IRS, but running an organized, professional, and informed business will reduce your chances of being audited, as well as prepare you if one does come along. Having a team of bookkeepers and accountants in your corner doesn’t hurt either, and at Bench, we’re always there for you.