Fernway DiarySM

Jul 26, 2021

The IRS recently announced plans to increase tax audits of small businesses by 50{d61ad4666dda706b731686a225909392f074403d16c1288901cab8f2cf34ab1f}. Whether a business owner is involved in the company’s day-to-day accounting or outsources it to a professional, the idea of the IRS combing through their books and records can be intimidating. After all, if the auditor finds a mistake, both the business and business owner could face additional taxes, penalties, and interest.
It is worth noting that even with a 50{d61ad4666dda706b731686a225909392f074403d16c1288901cab8f2cf34ab1f} increase in small business audits, only a small fraction of businesses will face an audit each year. Still, it is helpful to understand the kinds of things that may increase the chances of being selected and know what to expect from an IRS audit.

Common IRS Small Business Tax Audit Triggers

Any business can be randomly selected for an IRS audit. Even so, there are a few common audit triggers that may attract IRS scrutiny. Whenever possible, business owners and their tax professionals should avoid the following.

Excessive deductions

There is nothing wrong with claiming legitimate business expenses. However, claiming excessive deductions in relation to business income can be an audit trigger. Large deductions for business meals and travel expenses tend to draw scrutiny, as these areas are prone to abuse.

Excessive business miles

A small business owner who uses their personal vehicle for work is permitted to claim a deduction for business use. However, IRS rules require contemporaneous written records detailing the number of miles driven, the time and place of travel, and the business purpose of each trip. Excessive business miles can be an audit trigger – especially in industries that don’t typically spend much time behind the wheel — because the IRS knows businesses often fail to keep adequate mileage records.

Round numbers

Tracking every financial transaction and business mile tends to be low on the list of priorities for busy entrepreneurs. At tax time, they may be tempted to estimate certain items, using round numbers when they do so. The IRS is aware of this habit, so tax returns with a lot of big, round numbers can be an audit trigger.

Unreasonable shareholder salaries

Setting reasonable compensation for shareholders can be a delicate balancing act. S corporations have an incentive to pay shareholders a low salary to reduce self-employment tax. On the other end of the spectrum, C corporations are incentivized to pay shareholders high salaries to “zero out” profits and avoid double taxation. In either case, the IRS tends to scrutinize S corporation shareholders with very low salaries and C corporation shareholders with very high salaries.

Large “miscellaneous” deductions

The chart of accounts in most accounting software includes an account for “Other” or “Miscellaneous” expenses. Many businesses do have miscellaneous expenses, but these are typically small, one-time expenditures that don’t fit in another category. Small amounts included in this account likely won’t trigger an audit, whereas a large balance generally signals to the IRS that the business may be padding expenses to avoid taxes.

Preparing for an IRS Business Tax Audit

The IRS audits business tax returns in three ways.

• Correspondence audits. A correspondence audit is the most common type of IRS audit. Essentially, the business owner receives a letter from the IRS requesting additional documentation to support the positions taken and information reflected on the tax return.
• Office or desk audits. For an office audit, the IRS sends a letter requesting that the business owner meets with an examiner at the local IRS office.
• Field audits. During a field audit, one or more IRS revenue agents come to the place of business to inspect the company’s records and get a better understanding of business operations.

Correspondence audits are usually limited to one or two issues identified in the letter received from the IRS, while office and field audits are more in-depth. These tips can help business owners prepare.

Get expert help

Even if your tax return wasn’t prepared by a professional, hiring a professional tax advisor (CPA, Enrolled Agent, or tax attorney) to represent you during an IRS audit is a highly recommended. These professionals have experience dealing with IRS agents and auditors, can better navigate questions and advocate your tax positions. You may also request that a field audit takes place at their office instead of your place of business.

Prepare your responses

Before the meeting, the IRS examiner or revenue agent will provide a list of documents they would like to review. Gather all requested information and prepare to answer questions about any unexplained deposits, additional sources of income, or significant changes in expenses. If you don’t have some of the requested documentation, you may be able to reconstruct documents from third parties or other records with the help of your tax professional.

Answer only the questions asked and respond honestly and succinctly. If you don’t know the answer to a question, don’t guess. Instead, make a note of it and offer to follow up after the meeting.

Respond by the deadline

Each request from the IRS will have a deadline by which to respond. It is important to respond by the deadline. If you cannot make an appointment or gather the requested information by the deadline, communicate with the examiner to reschedule.

Being selected for an IRS audit can be frustrating, but being prepared, professional, and courteous to the revenue agent, even if you disagree with their assessment, can go a long way in getting your audit resolved satisfactorily. Fernway Solutions has an experienced team of tax professionals that can provide guidance and proactive audit defense strategies throughout the examination process, and communicate with the IRS on your behalf.

For more information, please contact your US tax advisory team at youradvisor@fernwaysolutions.com or visit us at www.fernwaysolutions.com.

Disclaimer:
The above content is intended to support the marketing of professional services and should not be construed as written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular tax situation. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Fernway Solutions assumes no obligation to inform the reader of any such changes.