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7 Tips to Avoid a Small Business Tax Audit

Receiving a notice that you are being audited can be very nerve-wracking, especially for a small business. You need to put all of your time and attention into actually running your company, so a tax audit can be particularly challenging.

Thankfully, tax audits are rare. Only about 2.5% of all small business owners will have to go through an audit. However, the chances of being the target of an audit this year or in the coming years may be growing. The IRS Deputy Commissioner of Examination for small businesses indicated in late 2020 that the agency intends to increase audits of small businesses and their investors by approximately 50% in 2021. He also shared that the IRS was hiring 50 specialized auditors in order to achieve that lofty goal.


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Tips for avoiding a tax audit

While the risk of being audited is still relatively low, no one likes to go through an audit. You can further decrease your chances of having to deal with the IRS by taking some additional steps before filing your return. Here are seven tips to help you avoid an audit.

1. Double-check all of your documents.

Simple errors raise red flags for the IRS. For example, if you get a Form 1099, you should be sure that the numbers you input on your return match the numbers on the 1099. Forms like 1099s are also sent to the IRS, and if they do not match up perfectly, that can trigger the need for a closer look at your full return.

Math mistakes or other errors will cause concern, too. Using software or a tax professional can help you avoid some of these more common red flags.

2. Avoid reporting a loss.

While you certainly want to take advantage of all of your expenses as a small business, reporting losses year after year will get the IRS’s attention. You are more likely to be audited if you report losses in two out of the last five years.

The IRS wants to be sure that the losses from your small business are the result of actual business functions, rather than because you are trying to avoid paying taxes in other areas. You run the risk of having the IRS classify your business as a hobby rather than a money-making venture if losses are prevalent each year.

3. Keep shareholder salaries reasonable.

If you provide salaries to your shareholders, they must be reasonable. Paying executives high salaries will help you avoid being taxed at the corporate level, but you can go overboard.

Learn what a reasonable salary for an executive in your industry is and use that number as a baseline. Stick to fair wages for the job being performed, and you are less likely to get the IRS’s attention.

4. Classify independent contractors and employees correctly.

If you have a high number of independent contractors compared to employees, that could be a problem from the IRS’s perspective. Some small business owners deliberately attempt to classify all of their workers as independent contractors to avoid having to pay taxes and benefits for them. Review IRS guidance about how to classify workers so you do not inadvertently misclassify your team. Classifying workers correctly will help you avoid a tax audit.

5. File on time.

Filing late increases your small business’s likelihood of an audit. When you file late, your return is not processed with everyone else’s return. That can mean that the IRS has more time to review your return for potential errors. By filing early or on time, you also avoid having to pay interest and late fees on any amount owed.

6. Avoid reporting estimated or rounded numbers.

Rounded numbers, such as $500 instead of $523, can be a sign that you are guessing at how much you spent or earned—and that you may not be reporting information correctly. Round numbers can signal that you are lazy, not reporting accurately because of a lack of records, or dishonest. You certainly do not want to convey any of those messages to the IRS. If you spent $13 on ink, report that you spent $13 on ink.

7. Report deductions accurately.

The IRS will take a closer look at returns that use certain deductions. These deductions are the most misused, so they warrant a more in-depth review in some circumstances.

  • Home office deduction. You can take a home office deduction for the business use of your home. However, if that amount seems to be too high for your type of business or for the size of your home, that could be a problem.
  • Meals and travel. You can deduct 50% of your meals and travel expenses for business purposes. Keep a close eye on this type of expense. If it gets out of hand for your type of business and income bracket, the IRS may want to take a closer look.
  • Charitable donations. Large gifts to charity are a big red flag for the IRS. While they are certainly helpful for the charity, they can also signify that the business is simply attempting to avoid having to pay taxes in some situations.

Pandemic tax relief and audits

Small business owners who took PPP loans or received EIDL grants may not be at any greater risk of IRS scrutiny than other businesses, but they may be audited by the SBA. The SBA has the right to spot-check PPP loans of any amount. The agency has indicated its intention to audit all loans greater than $2 million after lenders submit the borrower’s application for loan forgiveness. Similarly, businesses that received EIDL loans agreed as part of the application process that they would use the funds for approved purposes and provide records to the SBA for audit purposes upon request.

If your PPP or EIDL loan is audited, you can expect the audit to focus on: 

  • Your company’s eligibility for the loan at the time you applied for it. 
  • Whether the loan amount was used for allowed purposes under the CARES Act. 
  • Whether loan forgiveness was calculated correctly. 

Your payroll reports will likely be a key source of information demonstrating that you needed the funds and that the loan proceeds were used appropriately. You should maintain all PPP/EIDL loan documentation in your business records for at least six years from when your loan was forgiven or paid in full.

Finally, it is worth noting that any business claiming the Employee Retention Credit or availing itself of other Federal pandemic-related tax relief could be audited. If your business is the subject of an audit, in addition to the tips above, be prepared to demonstrate that the business was entitled to the tax relief claimed.

Get help with small business taxes

There’s no better time to check and re-check your tax return, especially in light of the IRS’s increased scrutiny over small business filings this year. Now is also a good time to gather your records documenting how PPP or EIDL loans were used in case of an audit from the SBA. If you have any legal questions about your particular tax situation, reach out to a Rocket Lawyer On Call® attorney for fast and affordable legal advice. 

This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.

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