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August 26, 2022

How to Protect Yourself from an Audit

Audits don’t have to be scary—here’s what you can do to prepare.

The Likelihood Of An Audit

The Internal Revenue Service (IRS) is set to receive $80 billion over the next decade. Some of that is for updating old computer systems and improving customer service, while a bulk of the budget will be towards increased enforcement in an effort to help the IRS collect more of the estimated $600 billion in taxes that go unpaid each year.

You might be wondering, will audits increase? Should small businesses worry?

With 87,000 new IRS agents and the current S-Corp audit rate very low, there is no doubt that audits will increase over time.

The IRS has needed to increase audits for years. When you don’t raise the tax rate, one of the best ways to grow the income tax being brought in through the IRS is to start auditing returns.

But “audit” doesn’t have to be a scary term or experience. There are things that small business owners can do to prepare and learn how to protect themselves from an audit.

How to Protect Yourself From An Audit

Separating Finances

First and foremost, you need to separate your business and personal finances (including income and expenses for both).

You’ll need two different bank accounts set up; one for your business income and expenses and another for personal finances.

You can start by obtaining an employer identification number (EIN) that is either attached to your social security number through the IRS or attached to a legal entity that is separate from yourself (like an LLC). With an EIN, you can open a business bank account that is dedicated to your business income and expenses only—this will make it easier to track your income and expenses when it comes time to report on taxes.

Start Bookkeeping

Step two is to make sure that you’re using a bookkeeping tool. There are some great, free tools out there you can use such as Xero. A bookkeeping tool will help sort your income and expenses into categories so that you can easily share that information with a tax professional.

Categorizing expenses will make it easier (and more accurate) when it comes time to complete your tax return and help prevent you from creating worrisome red flags.

Avoid Red Flags

Red flags are indicators that the IRS computer programs pick up on a tax return and flag for an audit and avoiding them are one of the best ways you can protect yourself from an audit. There are particular indicators they watch for: reasonable compensation from an S-Corp being too low or excessive expenses that are out of balance compared to what a sole proprietor is declaring as earnings.

For example, if you’re a real estate agent making $70K annually and you expense internet as $10k a month, that’s going to be a red flag.

So, get a separate bank account, have a good bookkeeping tool, and make sure you handle compensation correctly. If you do this, everything you’ll be doing will be in compliance and reported on your financial statements (meaning you’ll reduce the risk of an audit).

Be Wary Of Social Media Tax Advice And #TaxTips

Next, be careful of the advice you see on social media. We’re not going to call out any specific platforms or creators, but we can say that people often come to us with the idea that they can buy a car and write off the whole thing in the first year.

Many #influencers talk about Section 179 (a bonus depreciation rule for certain vehicles used in business), but they fail to provide full context. Some clickbait is too good to resist!

Deductions are nuanced and best done alongside a tax professional who can ensure that you depreciating purchases correctly. This is another great way to protect yourself from an audit. 

It’s a huge benefit in the tax code for business owners when done correctly, but when done improperly could have devastating consequences. If done incorrectly, you could raise a flag for an audit in which you will be responsible for paying the back taxes and other associated fines—the G-Wagon won’t be as fun anymore!

Pay (And File) Your Taxes On Time

A Quick Overview Of Filing Deadlines For Business Owners

The final step to make sure you’re ready for an audit is to pay and file your taxes on time.

If you’re a business owner, estimated tax payments are due on April 15, June 15, September 15, and January 15. You’re also required to file your business tax return (the 1120-S) if you’re an S-Corp by March 15 or September 15. If you file an extension, those can are due on April 15 or October 15.

By filing your taxes or requesting an extension on time, you’ll substantially reduce the likelihood that the IRS will need to audit your returns.

What To Do If You Are Audited

If you follow the steps above, your business will be in compliance and less likely to trigger an audit. If you do receive a letter from the IRS, one of the most important things to do is respond quickly.

People are anxious to read letters from the IRS, but out of sight does not equate to out of mind. An audit can cause anxiety to linger. So the best thing you can do is communicate in a timely response, request more time if you need it, and know that you have a right to representation (so if you need help, ask for it).

It’s important to note that the IRS will NEVER contact you by phone regarding an audit. Audit communication is done by traditional mail or in-person interviews; if you get a phone call from someone claiming to be from the IRS, it’s likely a scam.

The law requires you to keep all records you used to prepare your tax return for at least three years from the date the tax return was filed (having those items on hand will simplify the audit process).

Possible Outcomes Of An Audit

At the conclusion of the audit, there are three possible outcomes:

  • No change: you substantiate all items in review and no changes are needed.
  • Agreed: the IRS has proposed changes and you understand and agree with the changes.
  • Disagreed: the IRS has proposed changes and you understand but disagree with the changes.

The IRS has outlined some frequently asked questions and next steps if you disagree with an audit on their website. But as always, the Formations team is here to help if you have any questions.

Now You Know How To Protect Yourself and Your Business

Audits don’t have to be scary. By following these simple steps, you can reduce your likelihood of an audit. To recap, make sure you:

  • Separate your business income and expenses from your personal income and expenses
  • Track your categories for expenses
  • Have clean financial statements that will then translate to your tax return
  • Do any advanced level tax planning with a tax professional

Taking these steps will not only mitigate your risk of an audit, but they’ll offer you greater peace of mind. You’ll know exactly where your business stands financially, where you can invest, where to budget, and you can make more informed business decisions.

You are a business owner. And doing some of the best practices will make owning, running, and growing your business easier.