You’re an honest entrepreneur. You run your small business with integrity; you don’t cheat your customers, and you go the extra mile to make sure they’re satisfied. You keep meticulous records, and you work with a qualified accountant and tax professional to make sure you’ve got all of your business’ tax records properly organized and identified.
Yet, even with all of that preparation and good intention, an audit can still happen. When it does, the burden of proof is on you; you need to be able to demonstrate that every expense is legitimate, and answer for every source of income.
There are some specific elements on your tax return that are likely to trigger an audit by the IRS. While we can’t be sure about all of the factors that go into the decision, here are a few that are especially likely:
Request large tax refunds, year after year
This is one of the elements that the IRS uses to flag returns. The IRS uses a computer algorithm to assign a score to every person and business, with a higher score meaning a higher likelihood of having an error. The most common element that triggers this algorithm is having a large tax return every year.
In many cases, these large returns are legitimate; you might have several children, for example, or you might have taken advantage of specific tax rebates, credits, or incentives.
The best way to avoid a large tax return is to make sure you’re not overpaying throughout the year. If you file quarterly taxes, estimate what you owe on the low side. If your spouse works outside of the home, ask him to lower the amount of withholding in his check.
That doesn’t mean you should purposely not take deductions or credits, of course; just understand that doing so year after year can, eventually, lead to an audit.
Show a high ratio of expenses to revenue
If your business is making money but just barely, this sends a message to the IRS that something is probably amiss. If you have a business loss for several years in a row, for example, the IRS considers what you’re doing a hobby rather than a business.
Look at the ratio of expenses that you’re claiming for your business compared to revenue. If it leaves little profit, or even large profits but little in proportion to expenses, you’re likely to trigger an audit.
The best way to avoid this is to track the ratio of expenses to revenue closely. After a few years, there should be an ever-widening gap. If not, you may find yourself sitting across the table from an IRS agent.
Have significant changes from one year to the next
One thing the IRS system looks at is consistency. It operates on the assumption that each individual or business is going to be in a similar situation, from the tax perspective, from one year to the next.
This isn’t always realistic, of course, but it is a statistical probability. If your business suddenly takes off, takes a nose dive, or if you radically alter your business such that it dramatically changes all of your tax-related metrics, it could trigger an audit.
Provide incorrect data
Providing incorrect data regarding your social security number or the social security numbers of employees or family members can trigger an audit. Forgetting to report, or incorrectly reporting, information from a W-2 or 1099 will do the same.
This is one of the easier mistakes to avoid. Go through your tax return, line by line, and make sure that every number matches up the way it’s supposed to.
Not paying your tax bill
If you send in a lower amount than what you actually owe in taxes without offering an explanation, you’re probably going to face an audit. The IRS is going to do a more complete investigation of your tax return.
You can avoid this by filing a Form 9465 along with your tax return. This form is a request to pay your tax bill in installments. You’ll still be facing some fees and penalties for paying past the due date, but you’ll be able to pay off your tax burden over time – and avoid triggering an audit.
Even if you’ve been completely honest on your taxes, an audit can cost you. The burden of proof is on you, and so in many ways you’re at the mercy of the IRS. Don’t give the IRS a reason to look more closely at your taxes. Avoid these triggers whenever possible.
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