How to Avoid a Small Business Tax Audit

No one wants to go through a small business tax audit. Taxes are already stressful, and you don’t want to have to review them feeling like a cold IRS agent is breathing down your neck, just waiting for you to make a mistake.

Thankfully, with the right steps, you can usually avoid a tax audit. In this guide, we’ll discuss what you need to know, including what triggers a tax audit and what you can do to avoid one.

What Triggers a Tax Audit

For small businesses, tax audits are actually pretty uncommon; only a very small fraction of returns get audited. But if you’re notified that you’re being audited, your initial reaction might be panic or dread — especially if you did your utmost to file a good return. But let’s be clear: getting an audit doesn’t necessarily mean that there was an issue with your return. That’s because there are two primary causes that trigger a tax audit.

The fact is, the IRS randomly selects returns to audit each year, regardless of whether that return has issues or not (selection is based on a statistical formula). So you could just be the “unlucky” one who gets audited. Another common cause for an audit is when the IRS notices a discrepancy between your return and another tax form they receive. There are a few other “red flags” that could trigger an audit, too.

How to Avoid the Red Flags That Can Trigger Audits

There’s no way to guarantee that you’ll never be audited, but you can greatly reduce the risk by following a few strategies. We also highly recommend getting advice from a licensed CPA or tax attorney to get individualized advice for your unique business.

Pay quarterly estimated taxes

If your business will owe $500 or more in taxes, then you’ll be expected to make quarterly estimated tax payments. If you don’t, the IRS may suspect that you’re underpaying on your business income taxes (or worse, committing tax evasion) and investigate.

File taxes on time

It’s unrealistic for the IRS to investigate every single tax return with a fine-tooth comb, especially when millions come flooding in on April 15th. If you file late or even request an extension for extra time, however, your return is more isolated — and more likely to be flagged as problematic.

Double-check your numbers

For many small business owners, tax time is overwhelming and stressful because there is so much data to collect, add, and input. While it’s tempting to get your taxes over with as quickly as possible, it’s best to take your time to double-check all your numbers. Even if it’s not a substantial error and it’s just an honest mistake of transposing numbers, it can be an audit trigger.

Avoid repeatedly reporting a loss

Technically, you’re allowed to report business losses on your tax returns; after all, they happen sometimes. But it’s considered best practice to avoid repeatedly reporting losses on your business tax returns. Repeated losses can make the IRS suspect that your business is merely a hobby, or that you’re abusing the business form as a means to evade taxes.

Don’t round numbers or estimate

How often do you go to the store and see a round number on your receipt? Probably never, or only extremely rarely. So if you report a bunch of round numbers for your business expenses, your tax return may look fishy. Instead, keep detailed, accurate financial statements of your actual expenses and include those on your tax returns.

Make sure your home business deduction is legit

The home office deduction is a completely legitimate practice, but only if you do it correctly. Make sure the home office space is used exclusively for the business. And be sure to deduct the right percentages of qualifying expenses, matching IRS guidelines. If in doubt, consult with a tax professional for customized guidance for your home office deductions.

Ensure your deductions are accurate

Deductions are a business’s best friend for reducing their taxable income. But if you report your deductions incorrectly — especially if you overestimate them — you open yourself up to potential audits. Keep accurate records of your expenses so that you can prove your deductions match your actual business circumstances. This includes mileage deductions for using your personal vehicle for business purposes, equipment costs, and so on.

For more information on the different deductions you can make, check out our guide on small business tax deductions.

Follow IRS guidelines for classifying independent contractors

A lot of small business owners hire independent contractors to get help with business tasks without the expense and hassle of hiring employees. And if you’re legitimately hiring contractors, then that’s perfectly legitimate. But you can’t classify an employee as a contractor to avoid your employment tax liabilities. That’s against the law and a surefire way to get audited.

Avoid excessive cash transactions if possible

Cash transactions are legitimate, but generally they’re a lot harder to track and prove, as they’re much more ambiguous on your bank statements. Having an excessive number of cash transactions can raise red flags, especially for large transactions.

Make owner salaries reasonable

If you’re taxed as a C corporation or an S corporation, then you’re allowed to pay your corporate shareholders a salary. But paying too much or too little of a salary to your business partners can cause problems, signaling that you’re dodging certain taxes. For example, C corporations could potentially dodge income taxes by paying an unreasonably high salary to their qualifying shareholders. LLCs taxed as S corporations could dodge a portion of self-employment taxes by paying too low of a salary.

In general, the IRS expects you to pay a “reasonable salary” to your members or shareholders (qualifying business structures only). Keep your salaries in line with industry standards, and you’ll reduce the likelihood of an audit.

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