With a 0.5% IRS audit rate, it may seem rather unlikely that your small business will get audited. But, that is the exact problem of looking at averages. Although, on average that has been IRS’s audit rate, there are a few criteria that most start-ups meet, exposing them to a higher risk of an IRS audit. The question is what to do to minimize the impact on your business of such audit?
As most start-ups meet the following 3 criteria, the odds of an IRS audit are significantly higher.
First, being a small business subjects you to a higher audit rate. Small businesses in general have a higher likelihood of being audited as they pose a higher risk of tax evasion. IRS knows that deducting personal expenses as business can be very tempting to entrepreneurs. Let’s face it, how many of us have never been tempted to classify a “dinner with friends” as a business expense?
Second, most small businesses do not report income in their early years. IRS looks suspiciously at businesses that show little or no taxable earnings and have high levels of expense deductions. One statistic cites the audit rate to be as high as 2.15% when no taxable income is reported.
Third, simply being a “C” corporation increases the audit rate. A “C” corp. is twice as likely to get audited compared to an “S” corporation or a Partnership.
Most entrepreneurs are less concerned with bookkeeping than with creating breakthrough products. However, an audit by the IRS will consume so much of your resources in time and money. Most likely, grey area items will be contested. Will you have the time to gather the documentation and pull up the resources to fight the IRS?
The following few IRS secrets may save yourself a lot of trouble. There are 3 accounts that trigger an audit. These are Meals & Entertainment, Home Office and Automobile logs. Be extra careful when making those deduction choices and, if you are expecting a net loss for the year, be more diligent in keeping documentation. Those dinner receipts should clearly indicate the names and the nature of business discussion. And, if you are deducting the entire auto lease as business expense, the IRS will certainly want proof of the existence of a second personal car.
In addition, 2 general ledger accounts capture the IRS agent’s fancy: Repairs & Maintenance and Miscellaneous. When faced with grey area expenses, try to avoid categorizing them as Repairs & Maintenance or Miscellaneous expense. During an audit, those two accounts are heavily scrutinized by the IRS agent. Many tax evasion scams have utilized these accounts to park ineligible deductions and thus the IRS loves digging extra deep into them.
Although painful, keeping good documentation can save you a great deal of trouble during an IRS audit. Especially when your business is still in the growth phase with little or no earnings. Regardless of your accountant’s advice, avoid using “Repairs & Maintenance” or “Miscellaneous” expense categories as a catch-all, parking your grey area expenses. If you follow these advices, you will have the peace of mind if your business becomes the victim of an IRS audit.
