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Entrepreneurs are well-known for their fearlessness and steady hands. But even with the guts to brave the business world head-first, they still get anxiety attacks thinking about a tax audit.
Companies get audited for any number of reasons, but what makes some businesses more likely to be audited than others? Here are some issues that might lead to an IRS audit.
One of the most irresponsible things you can do as a business owner is combining your business and personal spending. IRS enforcement on this issue can be aggressive. The treatment of items like meals and entertainment, travel, automobiles, and housing are common areas of scrutiny. But any entrepreneur can attest that there’s a gray area when it comes to determining what’s considered business or personal expenses—especially early on.
Because of that ambiguity, the main rule of thumb is to document everything, so you can:
We recommend keeping up-to-date travel logs, receipts, and as much other supporting documentation as you can to justify the miles you drive and meals/necessities you expense… Also, don’t forget your tape measure if you plan on claiming that home office deduction!
Tax credits give a dollar-for-dollar reduction in tax liability, while deductions reduce liability at the taxpayer’s marginal rate. The process of claiming a tax credit can involve detailed record keeping and complex calculations. Even when taxpayers are 100% eligible for these credits, the IRS has historically found many errors in calculations, making them likely to scrutinize each claim thoroughly.
For example, the Research and Experimentation Credit is a common business tax credit subject to audits. The credit is based on qualifying types of research and development activities conducted in the United States.
Employers need to file payroll tax returns for all compensation to employees. The compensation amount reported as an expense for income tax returns should match the amount reported for payroll tax. Employers are fiduciarily responsible for payroll tax withheld, and need to transmit the tax in a timely fashion. The IRS is particularly harsh in enforcing fines for late payroll tax reporting!
If your business has a presence in a state—property, payroll, or sales—then you should look at the filing requirements for that state. Types of state taxes could include income, sales, franchise, and gross receipts taxes, but these requirements vary by state, which is why this can all get tricky.
If you have an office and employees in a state, your business is probably responsible for filing income and payroll tax returns in that state. While 100% of your income is included on your federal return, if you have sales, locations, or employees in multiple states, apportionment of your income is required to determine your liability in each one.
Psst! Do you have foreign business? If your business has foreign activities or shareholders, you should be aware of the required forms based on your type of business—forms 5471 or 5472. Failing to file or filing late can result in a $10,000 penalty per form, per year!
Donating to charity is a socially responsible way to save on business taxes while also spreading goodwill throughout your team. In fact, so many businesses add this to their end-of-year tax saving strategy that there’s an entire day and hashtag dedicated to #GivingTuesday, the first Tuesday of December.
The IRS wants proof for most charitable donations, either in the form of cash or property. While cash donations are easily documented by a check or receipt, non-cash items like furniture or equipment require documentation of fair market value and tax basis.
Be conservative when estimating the value of property. A two-year-old computer has practically no value. As always, documentation is crucial in case of an audit!
An inadvertent error probably won’t trigger an audit, but it will require time and effort to fix. Watch out for wrong or missing social security numbers, math mistakes, errors in figuring credits or deductions, and forms that aren’t signed or dated. While that small math error or basic typo might only warrant a quick notice for correction, that could be all it takes to grab enough attention for the IRS to flag your return and look for other potential areas to investigate.
Taxpayers should always keep accurate books and records, strictly segregate business and personal expenses, and maintain documentation of expenses.
Keep calm! The reality of being audited? It happens to the best of us—and it doesn’t mean the end of your business. To put yourself at ease, learn more about the different types of audits you might experience, how to get prepared and organized for your audit, and what you can do if your feel that the IRS is wrong about how much you owe.
Before you cross that road, look for legitimate strategies for saving on your taxes and, more importantly, best practices for making sure you take the right steps when you go to file in the first place.