One nightmare of every small business is a tax audit by the Internal Revenue Service. Even though you do everything right, as far as you know, on your income taxes, just the thought of an audit is enough to send you into a cold sweat. Preparing for an audit takes a lot of preparation time. It also takes a lot of money because most businesses depend on an accountant to help them through it.
Small businesses are about three times more likely to be audited than individuals. Here are some steps to take to prevent the IRS from auditing you.
- Skip the home office deduction. Even though the IRS looks more kindly on the home office deduction than they did in the past, it is still a red flag, especially if your home office deduction is large. If you claim a lot of home maintenance or utilities, the IRS will scrutinize that part of your return. If you claim both a home office and the expenses for an office you rent or own, this is an evener bigger red flag.
- If your business uses more subcontractors than employees, you are vulnerable to an audit. If you issue a lot of 1099 forms at the end of the year, you may be audited. The IRS looks carefully at businesses that use more subcontractors than employees as they wonder if you are avoiding paying payroll taxes.
- This sounds extremely basic, but keep your personal and business expenses separate. Keep a separate business bank account. Have a separate business credit card. Keep your business record keeping separate. File a Schedule C and claim your business expenses on Schedule C instead of Schedule A.
- Don't file a lot of Miscellaneous Expenses on Schedule A. If you file a large amount of expenses under "Other" on Schedule A under "Miscellaneous," that is a red flag for an audit. Instead, itemize those business expenses under the correct categories on Schedule C.
- Don't estimate expenses or income on your tax return. If you estimate the payment from a customer and that customer claims the payment as an expense and claims the exact payment, you are setting yourself up for an audit.
- Don't make math errors on your return or file a messy or handwritten return. If you make math errors, the IRS will look more closely at your return and that may trigger an audit. That is also true if you file a messy return.
- Be sure that you are using the proper accounting method for your business. All businesses can use the accrual accounting method but not all businesses can use the cash accounting method.
- Businesses have to show a profit three years out of every five years. If you don't, the IRS will classify your business as a hobby. The three out of five test satisfies the "profit motive" test that the IRS uses.
- Since the IRS is cracking down, they are looking at executive compensation. If large salaries are paid to officers of C corporations, they will look carefully at that corporation's tax return as the large salaries will reduce corporate income and, therefore, corporate tax liability.
- Pay your quarterly taxes! If you think you will owe $500 or more at the end of the tax year, pay quarterly taxes. If you are vigilant about paying your quarterly taxes, you will be less likely to get audited.