How to Outsmart an IRS Audit and Safeguard Your Finances

For a long time, the IRS struggled with insufficient human resources and funds. But with recent $80 funding, things are about to take a turn.

Though Treasury secretary Janet Yellen shares that the IRS has other goals, experts think the audit rate will rise from the current 4.1 out of 1000 returns.

Now, the word ”IRS audit” makes business owners uncomfortable. Negative feelings like — anxiety, fear, and anger are often associated with IRS audits. In Karla Dennis's (Founder of Karla Dennis and Associates) words: “They ( people ) don’t understand how the system works, and so they’re extremely fearful of audits.”

We agree.

To help you better understand the whole system, in this article, we dissected the IRS audit- How it works and what you can do to prevent it.

IRS Audit: A primer

Let’s start by addressing the elephant in the room: “what is an IRS audit?”

Simply put, an Audit is one of the IRS's ways to ensure that a business (or an individual) reports the information correctly and owes no taxes to the IRS. When you file a return, an auditor examines it. If he/she finds anything questionable, the return gets handed over to an examination group.

Now, most taxpayers have this impression: “IRS audit means I am in trouble.”

But be assured it is not always the case.

Random selection: IRS sometimes picks valid returns randomly to understand what a “norm” looks like in a specific case (or income bracket). These “samples” later help the IRS to set statistical rules to seek out actual shady tax returns.

Related examination: Your returns might get under scrutiny if your business partners/investors have some inconsistencies in their tax returns.

Usually, the IRS focuses on returns filed within the last 3 years. But in some cases, the timeline can extend up to 6 years.

How an IRS Audit works

If you are notified of an IRS audit, expect it to take place in either of two ways: an in-person interview or by mail.

During an in-person interview, the review of your documents and Q-A sessions will take place either at an IRS office, your place of business, or even at your residence. You will be notified about the interview beforehand with all the necessary information.

Auditing by mail is pretty straightforward. The IRS will request additional information on your income, expenses, and itemized deductions. If you have too many bills, invoices, and documents to produce, feel free to request an in-person audit.

Bonus tip: Auditors use these Audit techniques guides for uncovering information and mismatches. Don’t forget to take a look at these (separate guides for different industries) to get an idea of what you can expect during the audit.

Now the IRS may demand some documents during the audits for verification. It has already made a list, but here are a few examples for your convenience:

  • Invoice: It should include the date, the purpose, and how it relates to your business.
  • Bills: These should include the name of the person/organization receiving payment and the date.
  • Legal papers: You should be able to produce legal proof in case some legal matters have influenced your income/business.
  • Loan agreements: Your loan agreements must include the amount, names of the borrowers, terms etc.
  • Tickets: If you went on a trip and registered parts of the entire cost as business expenses, you should save the tickets.
  • Theft and loss documents: Some examples include Insurance documents detailing the full extent of loss and photos/videos displaying the damage.
  • Employment documents

Now, please note an IRS Audit doesn’t always end in you paying a hefty sum to the IRS. You have the option to legally disagree with the IRS and defend your position by providing proper evidence.

With all that said, having to stand up for yourself against IRS auditors is taxing. All that paperwork and back and forths eat up your personal and productive time. It’s better to prevent an audit in the first place. But what are the chances of you being cherry-picked?

What are your chances of getting audited?

It’s pretty hard to estimate one’s chances because there are several factors outside of one’s control that can lead to an audit.

However, you can make an educated guess by looking at numbers.

A report by Syracuse University's Transactional Records Access Clearinghouse found that in the fiscal year 2022, the IRS audited 626,204 returns which is less than FY 2021 (659,003).

The same report reveals

  • Individuals with less than $200000 income face an odd of 19 audits out of 1000 (0.19%).
  • Higher income and returns with Schedule C or F revenue increase the chances of IRS audits. Taxpayers in the $200k - $1M range (without schedule C or F) have a 0.49% chance. Bring Schedule C or F into the equation, and the chances jump to 1.03%.
  • Taxpayers in the $1M+ total personal income range have the highest odds of being audited, 1.27%.

One of the biggest reasons behind the dwindling number of audits is that the IRS is underfunded and understaffed. However, with new $80B funding, things will change soon (they have already hired 5000 new staff). So expect more audits in the near future.

IRS audit triggers:

IRS auditors pay extra attention when they come across certain red flags in your tax return. Ideally, you want to avoid those red flags altogether and not poke the sleeping bear. In any exceptional situation, don’t forget to save your records:

  • The IRS has already got copies of W2, 1099s, and 1098 and calculated how much you owe. If you fail to report all of your taxable income, you move onto the IRS’s red list of potential tax evaders.
  • Suspiciously big tax deductions often raise eyebrows. For instance, if you mention the cost of your personal car usage as a business expense, that could be a problem. Remember, the IRS compares itemized deductions and credits on your return to the average deductions claimed by other taxpayers of the same background and income bracket.
  • Any cash transaction that didn’t get reported can take you to the deep water. And no, you have no way to hide your such transactions without invoices. Why? Because under the Bank secrecy act, banks are liable to report such cash transactions. Also, payment settlement entities (Paypal, Vimeo, etc.) issue a 1099-K once your total received amount crosses the $600 mark.
  • Failing to issue information returns such as W2s or 1099s can draw unwanted attention too.
  • Misclassifying your employees( intentionally or not) is another audit trigger.
  • Registering hobby expenses as business expenses and then claiming tax deductions is a big no-no.
  • Home office deduction is another murky area. If you are not strictly using your space as your office or don’t comply with rules, the IRS might select you for an audit.

How to prevent an IRS audit:

Consider not being a sole proprietor:

The sole proprietorship has its advantages. You get to skip a lot of paperwork, taxes are relatively less complicated, and you keep all of your profits.

Yet, experts like Karlton Denis, tax strategist and CEO of Tax Alchemy, advise business owners to ditch sole proprietorship. And rightfully so.

IRS has a bias against sole proprietorship when it comes to tax auditing. Some stats suggest businesses with sole proprietorship status get audited 300% more.

In IRS’s defense, they have proper reasons:

  • Sole proprietor returns often include “substantial misreporting” of gross income and expenses.
  • 25% of sole proprietors reported a loss in 2006. No wonder the fact that all of them suffered a loss in business felt off to IRS auditors.
  • Sole proprietors allegedly underreported their incomes by 57%.

Yes, these are pretty outdated data, but that doesn’t stop the IRS from being extra strict. Therefore, err on the side of caution by registering your business as an LLC. Not only it protects you from audits, but also you get liability protection. Later on, you can even switch to an S-corporation. It will save you some hefty taxes.

Long story short, in addition to reducing your audit chances, you can even save taxes if you know what structure works best for your business.

Report all of your income

Your employees, contractors, and other parties send information using W2, 1099, and 1098 forms. The IRS collects such information and compares it with the total taxable income mentioned in your tax returns.

If the IRS finds any mismatch (read: you paid less tax than what you owed), your chances of being audited shot up through the roof.

So the obvious solution is, “Be honest and don’t hide any income.” It’s indeed a bit of good advice, but discrepancies often emerge in several other unexpected situations:

  • You misplaced a few invoices and mistakenly submitted the wrong amount. Now there is a mismatch between your tax returns and the 1099 that your contractor sent to the IRS.
  • You engage in a lot of cash transactions and don’t know how to keep track and report those to the IRS. In this situation, the IRS might spot a difference between your tax returns and 1099-K forms.

Long story short, you can be in trouble even when you have honest intentions.

So what is the solution?

“You have to be careful, even with simpler stuff.” says John Apisa, a CPA and partner at PKF O'Connor Davies LLP.

Here are a few ways to be careful:

  • Don’t submit your tax returns till you receive copies of the 1099 and W2 forms. Use those copies to verify your return before sending it to the IRS.
  • Use a separate bank account for your business. Link it to a bookkeeping solution such as Fincent. In this way, any transaction will not be lost, and you will find it easier while filing your taxes.
    To give you an idea, here is what it looks like. Fincent automatically updates all the transactions. You can even sort them using various tags easily.
  • Don’t round your numbers. For instance, when you pay $2245 for a work laptop, don’t report the cost as $2300 in your tax forms. Too many 100s and 50s in your tax forms raise the suspension, and the IRS might want to find out more. It is better to be safe and mention the actual price.

Avoid misclassifying your employees:

Legally, you, as a business owner, need to withhold, deposit, pay and report employment taxes, Medicare taxes, and unemployment taxes on your employees' behalf.

On the other hand, you don’t have that much responsibility if you hire independent contractors and freelancers.

This part is straightforward, right?

Well, if your understanding of who classifies as an employee doesn’t match with the IRS’s, it can become “the spark that lit the powderkeg.” To give you an example, if you consider a member of staff as a freelance contractor ( but in IRS’s definition, he/she is an employee) and don’t do your tax responsibility on that person’s behalf, the IRS might audit, on the grounds of tax evasion.

IRS uses the following yardsticks to classify a worker:

  • Behavioral: Does your company control or have the power to determine what and how a worker does his/her job?

    If you train a worker, set his/her working hours, and set strict guidelines, he/she is an employee in IRS’s book. If any worker, on the other hand, enjoys a lot of autonomy in terms of work hours and guidance, he/she might be a contractor.

  • Type of relationship: If the worker performs a key aspect of the business and/or you provide him/her with some benefits ( health insurance/ paid leaves), that’s an employee. IRS also takes account of the length of employment duration. The longer an individual is involved with your business, the higher chances of the IRS viewing him/her as an employee.

  • Financial: If the worker gets paid a salary or receives a set company wage, he/she would be classified as an employee. Contractors receive a flat fee per job or project.

You want to classify your members of staff based on these considerations. If any of them matches the IRS’s definition of an employee, you have to carry out your tax duties to prevent any IRS audit.

Be careful while reporting deductions.

As a self-employed person or a small business owner, you have multiple tax deduction opportunities - home office, business travel, start-ups, and many more.

However, some taxpayers can interpret the scope of these deductions differently (read, find loopholes), which may lead to potential tax fraud. There is no shortage of cases where a self-employed individual tried to avail home-office deductions just because he worked on his study table or someone attempted to pass his/her personal travel expenses as business expenses.

No wonder the IRS gets cautious when you file for those deductions. If things don’t match up, you may get an audit email from the IRS.

Also, charitable donations draw extra attention. When a business donates a large sum to a charity, the IRS sometimes views it as an attempt to tax evasion and investigates the situation.

Here is how to be safe:

  • Stay legal and claim only the deductions that match IRS’s guidelines. For example, you should file for home office deductions only if you use a part of your residence strictly as a home office.
  • Save your documents. You should be able to produce invoices, receipts, and other proofs to back up your claim. IRS staff operate with a “guilty unless proven innocent” mentality, so you don’t want to face them unprepared.

Think before you report your losses:

IRS can go easy on you if your business is going through a rough patch. Unfortunately, some business owners exploit it by showing made-up losses intentionally.

However, it can misfire spectacularly.

IRS’s perspective is that if you fail to make a profit in three out of the last five years, it is a hobby, not a business. Therefore, you get no tax deductions from hobby-related purchases, investments, or losses. Moreover, IRS agents might even come back to retrieve all the benefits you received in previous years based on your business operations.

The best advice: If you want business-related tax deductions, you should do your best to make profits. And don’t report losses for some peanut amounts of tax deductions.

Conclusion

Being organized is the best way to prevent any tax audit. When you have all the transaction details and documents, you won’t make any errors during tax filing, you won’t miss any tax deadlines, and most importantly, you will be ready if you have to support your claims.

Fincent helps you with staying organized. We have already shown you how it can keep track of all the transactions without your involvement. It can do way more than that - creating invoices, following ups, saving important documents, and so on. Long story short, Fincent makes proper bookkeeping effortless.