Small Business Advice

What does being audited mean?

We tackle the myths surrounding small business audits (from Sole Prop to LLC), and easy best practices to avoid being audited at tax time

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What Happens When you Get Audited?

While the chances are low that your small business will be subject to an audit, there are also a lot of myths surrounding audits. For example, that low income businesses don’t get audited, that audits are always done quickly or that audits will only happen the year you file. It can be stressful to find out that the IRS has at least three years to audit a tax return (and in some cases forever). That means your return last year could come back to haunt you next year, either because of a specific discrepancy or random selection. Thinking about how to organize your finances throughout the year is the best way to make tax time (and any potential audits) far less painful. There’s a lot of information available to help you with your taxes, but here are some of the main things you can do to minimize scrutiny from the IRS.

(One important note: If the IRS does contact you, it will be always be through the mail, not by phone.)

Keep Business Finances Clearly Organized

If you are an incorporated business, the IRS requires that you keep your business finances in a separate account from your personal finances. But even if you are an unincorporated sole-prop, it's still a good idea to run your business finances out of a separate bank account. Keeping your records organized can help you prevent an audit in the first place because you’re less likely to forget something or make a mistake. 

With Covid-19, Correspondence Examinations (audits by mail) will probably increase as compared to Field Examinations (face to face audits). If you do get audited, having everything appropriately filed and organized will help you navigate the audit with much less stress. 

So, if you already have your business finances moving in and out of a separate account, what additional records should you keep if you're a small-business owner?

According to the IRS:

“You must keep all employment tax records for at least four years after the tax becomes due or is paid, whichever is later.

Other important documents you should keep include records for gross receipts, such as cash register tapes, bank deposit slips, receipt books, invoices, credit card charge slips, and forms 1099 miscellaneous.

Proof of purchases -- for instance, cancelled checks, cash register tape receipts, credit card sales slips, and invoices.

Expense documents, which include invoices, cancelled checks, cash register tapes, account statements, credit card sales slips, and petty cash slips for small payments.

Documents to verify your assets like purchase and sales invoices, real estate closing statements, and cancelled checks.

Also, you should normally keep records relating to your business assets until at least three years after you sell or otherwise dispose of the property.

Examples of these assets include building, machinery, equipment, and office furniture or fixtures purchased and used in your business.”

If you can figure out a filing system that works for you and fold it into your regular business practices, organizing your business information doesn’t have to derail your plans every tax season and you can be sure you’re filing as accurately as possible. Bookkeeping software is especially helpful for keeping track of expenses, receipts, donations and sales (if you already have a Nearside account and need accounting software, you can actually get a discount on Quickbooks.)

Be Consistent

Not only do you want to make sure your numbers are consistent by using tax software and avoiding making calculation errors, keeping your business relatively consistent year to year helps in decreasing the likelihood of raising red flags at the IRS. Finances will naturally ebb and flow over time, but large, sudden, dramatic changes in income or losses are likely to draw attention. That means limiting  spikes in charitable donations, salary increases that don’t line up with the standard industry range or deductions that don’t line up with the current IRS guidelines.

Similarly, one of the main things they look for is a lifestyle inconsistent with your income. 

Have Sensible Deductions

Obviously, you don’t want to deduct anything outrageous like a jetski (unless, of course, you own and operate a marine motorsport center), but understanding what counts as a deduction can be confusing. According to the IRS you want your deductions to be both “ordinary and necessary.” 

As they put it: 

“An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

It is important to separate business expenses from the expenses used to figure the cost of goods sold, Capital Expenses, and Personal Expenses.”

If you’d like to see more about how they define capital and personal expenses, they have that and more available here. You can also check that you’re up to date with the latest IRS tax reforms on what qualifies as a deduction (for example, they may have updated the restrictions around claiming meals as a business expense since you last checked).

Tailor Your Tax Knowledge to Your Situation

No two businesses or tax returns are exactly the same. Small businesses get audited at different rates depending on the type of business and the amount of income, so you want to be aware of what applies to your business at different stages of its life. For instance if you’re part of a married couple running a business together, there are still different ways you might file, depending on your roles in the business. Or if your business changed from a sole proprietorship to a corporation, there will be different tax form requirements. When you feel comfortable with how you’ll be filing your federal taxes, check out business tax information for your state to better understand requirements specific to your area.

Red Flags:

As you manage your books throughout the year, and especially during tax filing time, be sure to keep these “red flags” in mind, that are more likely to increase your chances of getting audited:

  1. Centering your business around digital currency / cryptocurrency like BitCoin
  2. Errors in reporting taxable income, including cash payments and other earnings
  3. A lot of cash transactions / cash transactions with unreliable paper trails
  4. Reporting a loss (Sole Prop: Schedule C filings)  / Consistent net loses / excessive expense reporting
  5. Bad math: often revealed by using rounded or averaged numbers, and not using decimals
  6. Excessive business vehicle use (as it can appear you’re claiming personal use as work use)
  7. Too many deductions without consulting a qualified accountant
  8. Late filing

If you have your expenses tracked and your books in order, navigating an audit may not be as painful as some people claim. We recommend using a qualified tax professional, and at least reputable bookkeeping software (like quickbooks) for this reason. However, if you follow the IRS’ tips throughout the year, you’re less likely to encounter an audit at all, and can continue running your business without interruption. 

Originally Published: 09/22/2020

Updated On: 09/14/2021

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