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How Small Businesses Can Avoid a Tax Audit

October 22, 2019

Today, many things keep small businesses up at night. Whether it is a computer virus, faulty bookkeeping software, or late audit notifications, small business owners have to navigate cautiously.

Contemporarily, one out of every hundred businesses face audits every year. Naturally, you do not want to be a part of that precarious circle. The current discourse surrounding the IRS is misguided. So long as you are not actively committing fraud or misrepresenting business income, your business will come out fine.

Conversely, the IRS audit gets scarier when small businesses do not seek professional help to find out about their unpaid taxes and budget constraints. An experienced tax firm can make a huge difference and give you that much-needed push to thrive in the market.

Small businesses often exaggerate or fail to make the right business deductions. The same mechanism applies when you earn more than $1 million and incorporate as an LLC to protect your business assets.

Here are some of the fundamental things small businesses should keep in mind to avoid the tax audit nightmare.

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Why Small Businesses Face Tax Audits

The fact is, there is only so much small businesses can do to avoid a tax audit. Many reasons can trigger a tax audit that may be out of your control. Furthermore, the IRS practices a randomized method to select a tax audit of businesses that reek of fraud or criminal negligence.

For example, your business partner or investor could be part of an unlawful activity that prompts the IRS to audit your business. In simple terms, there is no hit-and-miss rule when it comes to the applicability of tax audits.

 Authentic and Prompt Filing

To thwart suspicion in the eyes of the IRS, you should authentically file your annual tax returns on time. It does not matter if your business did not earn a profit, failure to file and submit tax returns makes you suspicious in front of the IRS.

In addition, filing tax returns with incomplete information hints that you are likely hiding something from the tax authorities. Similarly, you cannot make unrealistic excuses or childish claims for not filing taxes before the deadline.

Small business owners have the flexibility of time to calculate the estimated taxes of each quarter every year. Therefore, you should be able to calculate and make tax payments to the respective state or federal authorities on time.

 Don’t change the Numbers

Small businesses foolishly assume that the IRS gets most of the tax information from you. Though you may be the primary source of information, the IRS authority has enough resources to gather necessary data from external sources such as vendors or employees.

Moreover, the IRS receives copies of W-2s and 1099s for self-employed individuals. Similarly, Sole-proprietors should mention collective information about profits and losses of the year in Schedule C.

The IRS takes it seriously when you deliberately attempt to tweak your financial statement numbers. Practically, it is a waste of time since the IRS double checks and compares your reports. Furthermore, denial can lead to even more disastrous consequences. However, you should explain if you make unintentional numerical errors in your tax filing.

 Don’t Overdo Business Deductions

Logically, small business owners tend to make the most out of deductions. And why wouldn't they? It's a perfect strategy to remain competitive in the market and increase business growth. But businesses do not often realize rightful intentions.

The truth is, the majority of the small businesses make the mistake of using undeserved deductions. Discriminate Income Function (DIF), for instance, is the comparison software IRS uses to balance your business income and amount of deductions.

If your tax bracket, for example, highlights ten deductions and you've made 150; you will inevitably get a call or visit from an IRS agent to discard unnecessary deductions.

Now, it shouldn't demoralize your spirit to enjoy the benefits of lawful deductions. Therefore, you should have no fear whatsoever to make legal deductions, such as counting the home office as an expense.

Also, don’t treat miscellaneous deductions in equal measure. It means there’s a high probability that a significant number of your various expenses don't qualify as legitimate deductions. Currently, the IRS has informed taxpayers not to add misclassified miscellaneous deductions that may have uncertain value.

Travel expenses and car mileage are two of the most misunderstood and misused tax deductions. The trick is not to exaggerate such deductions, or else you will have to witness the unspoken glare of the IRS. Besides, small businesses don’t have to exploit deductions since they relatively get more opportunities than individuals.

The most immature mistake is to write off your car expenses completely. It would be unreasonable to assume that you strictly used your car for office and took no trips to shop groceries or take care of personal errands.

The same rules apply to when you completely write-off your business meals and raise red flags. However, as per the Tax Cuts and Jobs Act (TCJA), the federal tax authorities don’t allow business deductions that solely involve entertainment.

 Don’t Round Up Numeric Figures

When you round up your numeric figure as odd numbers, it sends a wrong message to the IRS. The federal tax authority has insisted that the majority of tax evaders round up numbers or try to remember past income.

Sure, your intention may be to look consistent, but it is an unethical business practice in the eyes of the IRS. You can, however, round up the nearest dollar value. But rounding a significant expense value (i.e., $2500, $3000) can be detrimental for your business.

 Avoid Contradictions

It is imperative to understand that the IRS thoroughly reviews your tax returns and as well as business returns. Thus, if you live a luxurious private life while your business barely shows a profit, the IRS is bound to calculate, compare, and assess your presented contradictions.

In simple terms, you don’t want to create an imbalance between your business and personal tax returns. This discontent is usually associated with small businesses that mainly deal with cash and ultimately fail to report some part of the earnings to the IRS.

 Losing Money is Not Always Bad

It's great if your business shows the growth from high sales or long-term investments for a year or two. However, if you showcase a business growth without complete interruption, the IRS is going to wonder about your tax situation.

No business achieves optimal growth without struggle. And that should make perfect sense to small businesses. Therefore, it is reasonable to highlight a previous figure where you suffered a business loss. But when you state continuous cash profits, it practically means you are not reporting correctly.

 Provide Relevant Documentation

You should provide all the necessary to the IRS that is pertinent to your annual business income. Documentation is all about preparation, the more aware you are about your profits, the easier it will be for you to assemble and submit the required documents.

Also, don’t lose the comprehensive record of your business’ receipts and invoices that could save you in front of the IRS. Your goal should be to document every step and expense of your business to achieve long-term success.

If you’ve made a business deal with the local government, it would be wise to document your plans for expansion. You can add this information to your tax return. It may take some time to gather around complete information, but it will, after all, prevent an audit.

 Don’t Hide Business Growth

If your income doubles or triples from the last year and you’re still making deductions of more than $10,000 is a direct violation of Section 179. It's like hiding your newfound profits under the rug and assuming no one's going to notice. It'll send more alarms to the IRS than you can imagine. After that, you can expect an auditor to come knocking down on your door.

 Adjust Your Perception towards the IRS

You shouldn't have a preconceived bias towards the IRS. It's not as if the IRS agents are out there to get you personally. It's all about accountability and making sure that you are operating a clean business. The IRS prefers to process clean tax returns rather than spend hours to inform you about uncollected taxes.

 Structure Your Business as an LLC

There's a reason why small businesses face audits more frequently than big corporations. And that's partly because of the lack of financial competency and organizational scalability. Therefore, it makes sense to scale up the operations through a business structure that helps you grow.

The formation of your business structure as a limited liability company (LLC) allows you to pay back the creditors in dire circumstances. Furthermore, your business will have a higher chance of acquiring business loans from reputable banks. Also, you can make more deductions as an LLC, such as retirement plans and employee healthcare.

Final Thoughts

The fear of audit shouldn’t impact your ability to make sound business decisions. Furthermore, small businesses shouldn’t panic and automatically think about government penalties and prison time. Instead, comprehensive paperwork, polite cooperation, and expert guidance would make the possibility of an audit vanish.

Keep your cards on the table when you hire a professional tax specialist or accountant. As you put trust put in your tax expert, they will be able to find more mistakes to keep your business out of trouble and even help you move in the right direction. With Halon Private Client we make sure that you are always tax ready so you don't have to worry about audits.

Christopher Ragain, CPA

Christopher Ragain, CPA is the founder of Halon Tax and one of the industries top authorities on micro-business taxation and tax planning.

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