How to Avoid Triggering an IRS Audit
Latest posts by Bruce A. Willey, J.D., C.P.A (see all)
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It’s the dread of many a business owner – getting audited by the Internal Revenue Service. Facing an IRS audit can be a complicated and potentially expensive distraction for your business, particularly if you’re a startup. In reality, fortunately, the number of returns audited in any year is very small. Sources estimate about 1% of all individual returns filed get audited and the percentage of higher-earning individual tax returns being examined is closer to 5%. Good odds for you to escape the audit process entirely.
To make those odds even better, there are definitely things you can do to try to stay under the radar of the IRS. Below, I share with you my experiences working with numerous business owners in helping them avoid five classic kinds of audit triggers I’ve seen over the years:
1. Failure of the Owner to Pay Themselves
The temptation of an S Corporation owner is to receive all of their compensation in the form of a draw or distribution. The IRS requires an S Corporation owner who also provides services to the corporation to pay themselves a reasonable salary or wage for the value of the services provided. I tell clients that they should review the tasks they perform for the business and then figure out what they would have to pay someone else to do that work. If the compensation to the owner is too low, the IRS may re-characterize some or all other income received as compensation.
2. Excessive Expenses Relative to Income
Particularly in the first few years of a business, it is common to have losses in the business. You wouldn’t think that these entities would be the target of IRS scrutiny, but they often are, as many of the expenses deducted in those initial years should have been deferred as the future benefit outweighs the present benefit. Ask yourself if the expense you are deducting produced greater benefits now or if the benefit is for the future. If the expenditure was future-based, defer a portion of the deduction.
3. Excessive Expense Categories
Certain businesses naturally have a higher amount of expenses in certain categories such as insurance, rent, and subcontract labor. Though it may be perfectly natural for your business, these increased percentages can cause an audit. For instance, a gas station or a restaurant may have higher insurance costs. Simply document the expense and you should be fine.
Additionally, if you typically put that pile of "not quite sure where they go" expenses into miscellaneous expense, then that can draw attention as well. We recommend that clients put those items which are question marks into an "ask accountants" folder that we add to the general ledger. Then we know to ask and you don’t have to worry about forgetting about it throughout the year.
4. Personal Type Expenses within the Business
If your business has expenses that can appear to be personal in nature, even though they could very well be legitimate business deductions, the IRS could want a closer look. For example, you could have cell phones, subscriptions, entertainment expenses which could draw attention. I tell my clients if it’s more personal than business, then prorate or skip the deduction. You have to keep great records for this type of expense; including documentation of the business purpose (of course we recommend you keep records of all business expenses).
5. Unusual Expenses on Your Return
If your return includes an unusual transaction, then the IRS may want to review the transaction to make sure it is properly accounted for in the company’s records. Businesses that take in or pay in cash fall into this category. I had a client who once wired money out of the company for a personal reason, off-shore betting. That triggered an audit. Remember that the IRS will find other ways to verify what you did, so accurate records are a must.
By avoiding the triggers, keeping adequate documents and records of your transactions and managing taxes as you would other parts of your business, you can help keep the prospects and potential distractions of an audit to a minimum and focus your energies on growing your business.