How small businesses can avoid a tax audit

By Bailey McCann, Funding Gates

Bailey McCann

First the bad news – small businesses are often the go-to target for the IRS if they are looking at who to audit.  Small businesses take a number of deductions that can be hard to justify without rock solid paperwork and receipts (like the infamous home office deduction).  There is some good news, however. For example, if you’re an LLC you can often fly under the radar.  IRS auditors are going to look first at cash businesses – restaurants, salons, any job where under reporting of tips is common.  From there they move on to small businesses that are sole proprietorships, and/or take a lot of deductions.

This isn’t meant to keep you from taking those deductions, but if you do, you’re going to want to have your ducks in a row in terms of paperwork.  Returns that get flagged for audit are typically pulled out because they don’t fit neatly within your peer group of returns.  Say you report you made $40,000 and you took $20,000 in deductions. This is going to set off some red flags.  Those deductions could be fully legitimate, but the IRS is going to want to take a look at the paperwork.

Making yourself or your business an LLC or corporation can take some of the heat off, as deductions for those entities are different and often greater. Including explanations like photo copies of relevant receipts or additional forms can also help the IRS agent who will take a manual look through your return if you get flagged in the system. 

Other areas to consider are expenses and losses that the IRS often looks for in audit-sensitive returns – these can be bad debts, or medical expenses – really any kind of major loss is going to require a paper trail. Incomplete returns can also raise a red flag because IRS agents are going to want to know if those omissions were deliberate.  Remember, ignorance of the law is no excuse, but the IRS is more likely to settle with individuals who just made an honest mistake and are willing to cooperate. In some cases these settlements can be reached without a full audit.  

Another way to avoid an audit is to file a complete return the first time even if this means requesting an extension.  Amended returns are going to be subject to greater scrutiny even though you’re within your legal rights to amend returns for up to three years.  Think of it this way: auditors are going to wonder what was missed the first time and why, especially if it results in an additional refund to you.

The core goal here is to avoid the big flags and stay neatly in your peer group.  If you have a more complex return, you’ll want to work with a professional tax preparer and also ensure that you have very good documentation.  Accountants will often tell you to double and triple check your figures, as some of the most common mistakes are data entry errors like transposing numbers or getting off by one field. Doing this will call your return into question even if you did nothing wrong.

Along with this you should avoid entering all round numbers on your return. It looks like you’re estimating business figures and it makes agents wonder what your records really look like.  

Now, overall the probability of getting audited is low, but remember, this probability increases exponentially when you start making common mistakes or stand out amongst the average filer.  You can never truly avoid an audit, but you can be careful.  The most important thing to be sure of is that if you ARE audited, you have all the paperwork you need to support your initial return.

Bailey McCann is a writer for Funding Gates, the accounts receivable software for small businesses that allows them to track, organize and manage open invoices all with simple clicks. Bailey enjoys writing on business, finance and technology. She regularly covers topics of interest to entrepreneurs, investors and fund managers.