An IRS audit can be intimidating for small business owners. While the chances of being audited are relatively low, it’s important to be aware of the common triggers that can increase the likelihood of an audit.
Although IRS audits on small businesses are not frequent, there has been a notable escalation in their activities in recent years. Congress’s passing of the Inflation Reduction Act in August 2022 led to an $80 billion fund for the IRS, $45 billion of which is dedicated to enforcement.
The risks of audits may be reduced, but complete elimination is impossible. Some audits are circumstantial while others are due to errors or omissions by the taxpayer.
Are you aware of these IRS audit triggers?
By understanding these triggers and taking proactive steps to avoid them, you can minimize the risk and ensure smooth tax compliance. In this blog post, we will discuss six common triggers that can often lead to an IRS audit:
Failing to Report Income
Businesses must report all forms of income, regardless of how minor some may seem. This includes primary business income and income received from other sources, such as renting out office space, freelancing services, interest from business savings accounts, or even bartering exchanges of goods or services.
Whether deliberate or due to oversight, income under-reporting is a key audit trigger. The IRS cross-checks information on the 1099 forms sent to your business with that on your tax return. Any discrepancies could raise a flag for an audit. Additionally, with gig work or side hustles becoming more prevalent, the IRS is taking measures to maintain records of personal earnings.
Significant Discrepancies in Reported Income
Significant discrepancies in reported income can also catch the attention of the IRS and trigger an audit. If your reported income significantly deviates from industry norms or previous years’ income, it may raise suspicion.
To avoid this trigger, it’s important to maintain accurate financial records and report income consistently. Document all sources of income and ensure that your records align with the income reported on your tax returns. If there are legitimate reasons for fluctuations in income, be prepared to provide supporting documentation to the IRS.
Excessive Business Deductions and Expenses
While legitimate business deductions are allowed, excessive or unjustifiable deductions and expenses can trigger an IRS audit. Deductions that are disproportionate to your income or industry standards can be flagged. We also shared 11 small business tax deductions you must watch out for and avoid.
Review IRS guidelines for specific deductions that may draw more scrutiny. By accurately claiming deductions and avoiding excessive or unjustifiable expenses, you can minimize the risk of an audit.
Large amounts of cash transactions
Businesses that regularly engage in significant cash transactions often attract IRS attention. The IRS views these transactions with more suspicion due to the increased possibility of unreported income. This does not imply that cash transactions are problematic, but maintaining detailed records and accurate reporting is essential.
Errors and Discrepancies in Reporting
Sloppy bookkeeping and reporting, including typos, misclassifications, or discrepancies between what’s reported and the actual financial records, can initiate an audit. Even seemingly minor mistakes, such as incorrect expense totals or missing 1099 forms can prompt IRS concerns.
Overly rounded figures can be flagged as well. It’s improbable for all your financial data to consistently end with rounded numbers like fives, tens, or even thousands. These “picture-perfect” digits can alert the IRS to dive deeper into your tax reports.
The IRS believes that if inaccuracies exist in a critical area like tax reporting, it could mean carelessness in other financial aspects of your business.
Consistently Reporting Losses
While it’s not uncommon for businesses to report losses, particularly in their early years, continuous losses year after year can trigger an IRS audit. The IRS may want to ensure that the business is not artificially creating losses to offset other income, or whether the business is genuinely for profit.
According to IRS guidelines, if your business makes money in three out of five consecutive years, it’s typically presumed that it is a profit-driven enterprise. If your business is legitimate but continues to generate losses, ensure that you have complete and accurate records to avoid it being reclassified as a hobby.
Proactive Steps to Avoid IRS Audit Triggers
Understanding and addressing these common audit triggers that can lead to an IRS audit serves as a proactive approach to maintaining your business’s financial health. By remaining diligent in tax reporting, keeping accurate records, and avoiding the pitfalls outlined in this article, you can steer clear of potential audit complications.
Working with a tax professional or a trusted tax software platform is always recommended to systematize your reporting process and help ensure accuracy. Remember, an ounce of prevention is worth a pound of cure, especially when managing your business’s taxes.
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