16 Tips to Avoid a Tax Audit of Your Small Business Return

What is a business IRS tax audit?

When you file your business taxes, you give the IRS detailed information about your company’s cash flow. Your cash flow includes the business’s total income, total costs, and any deductions or credits you’re claiming for the previous tax year. 

The problem begins if the IRS believes you made a mistake on your business’s return or that you’re not being forthright. If that happens, the agency will commit its resources to ensure everything is accurately reported.

IRS auditors have three years after your tax returns were submitted to call for an audit. Audits are done in one of three ways: by mail, at an IRS office or in person at your business. For each method, an IRS agent will review your financial records to find any issues in your return and ask questions about your business’s records.

Once the IRS audit is complete and a determination is made, you must either address the issues at hand or request an appeal with the IRS Office of Appeals within 30 days.

When are audits conducted?

According to the IRS’s website, being selected for an audit doesn’t necessarily mean there’s a problem. The agency selects audit subjects using a statistical formula based on a series of norms from “audits of a statistically valid random sample of returns, as part of the National Research Program the IRS conducts.” 

The agency also uses related examinations, which it selects when returns are likely to “involve issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for audit.”

How to avoid a business tax audit

You can lower your odds of a tax audit by taking specific steps with your tax return and avoiding others — you just need a good DIF score. DIF stands for discriminate information function, a program the IRS uses to determine if your small business-related tax return is ripe for an audit. 

While DIF details are secret, the steps below can help you reduce your odds of being audited. Each choice you make — how to file, when to file and which deductions to claim — impacts your audit odds. 

Here are 16 actions you can take to avoid a business tax audit:

1. Be accurate, thorough, and neat. Sloppy returns and math errors raise flags. Tax preparation software makes your return look more professional and helps you avoid mistakes. Accuracy starts with keeping good records, because if the IRS ever questions anything on your return, the burden is on you to prove it’s correct. If your records are sloppy, proving you’re right will be a challenge. Choosing the right business accounting software is one of the best ways to help keep accurate records.
2. Refrain from rounding numbers. Using only rounded numbers to calculate your income and losses may make the process easier for you in the moment. However, any inconsistencies will immediately stand out as a red flag for an IRS auditor. Cutting corners here could cause you issues later.
3. Explain yourself clearly. Avoid vague business expense categories, such as the infamous category some business owners use called “miscellaneous.” If your business is claiming unusual deductions of some kind — anything an IRS reviewer might not have come across a thousand times before — provide an explanation or documentation.
4. File electronically. Electronic tax return filings are convenient and, in some cases, even required. Electronic filing gives the IRS fast access to 100 percent of your return, and in nearly every instance, online tax-filing solutions can check your information for errors. Using the built-in tools can ensure your data is accurate. Many solutions like TurboTax offer an audit protection guarantee under which you will receive representation should an audit be initiated against you.
5. Make your estimated tax payments on time. Late quarterly estimated payments, nonpayments, and underestimated amounts draw the ire of the IRS. Know the deadlines and meet them. File 1099s and W-2s using easy online tax services.

6. File on time. Filing for an extension is easy, so there’s little reason to miss the initial deadline. Remember that any money you owe is still due by the original filing deadline, and the extra time is for doing the paperwork.
7. Beware of your income-to-deduction ratio. Your tax-audit odds for a small business rise if the difference between expenses and income exceeds 52 percent. Total deductions are only part of it. One especially large deduction can also raise flags, even if others are small or in line with other businesses in your industry.
8. Be wary of taking a home-office deduction. Tax returns that include a deduction for a home office are a prime IRS target. If you plan to take a home office tax deduction, make sure you know the rules. A home office must be a completely separate room or area used exclusively for business. A CPA can be invaluable in helping you do it right, or perhaps deciding the benefits aren’t worth the hassle.
9. Only write off eligible travel and meals. With the passage of the Taxes and Jobs Act of 2017, businesses are only allowed to deduct 50 percent of their meals and travel expenses conducted for business purposes.
10. Watch those startup cost deductions. Many startup entrepreneurs and new business owners assume that the money they’ve spent to get the business up and running can be deducted immediately. However, that’s not always the case, and many startup costs must be depreciated over time.
11. Don’t mix personal and business deductions. The IRS is on the lookout for small business owners who try to deduct travel, entertainment or other costs that aren’t business-related. Make sure you understand the rules on what portion of business travel and entertainment costs are allowable as a deduction. Avoid taking mileage deductions for personal vehicle use, since that’s another IRS audit hotspot.
12. Make your hobby a true business. If the business you are claiming all those deductions for looks more like a hobby to the IRS, you could trigger an audit and end up owing back taxes. A real business has revenues at least some of the time and looks, acts and spends like a business.
13. Reconsider your business structure. Owners of a sole proprietorship who file a Schedule C for each business get audited the most. To avoid the higher risk of sole proprietor audits, consider making your business a corporation or limited liability company.

14. Hire a CPA or other tax pro. Tax rules that affect small businesses are impossibly complex, far-reaching and downright confusing. Even for relatively straightforward situations, finding a tax consultant or hiring a certified public accountant for guidance can be a huge help in avoiding audit triggers. Check online sources to find an accounting firm, tax attorney or CPA in your area.
15. Avoid the independent contractor trap. Another IRS favorite is misclassified workers. If your business hires freelancers and other types of independent contractors, ensure they qualify for independent contractor status. Otherwise, the IRS may determine that they are employees and stick you with a hefty bill for back payroll taxes plus penalties.
16. Don’t “forget” to report income. The one thing the IRS hates above all else is unreported income. And don’t kid yourself — tax agencies are more sophisticated about tracing money than ever. The IRS has extensive data on typical income levels and deductions for every type of business that exists. If your numbers are out of line with those of similar businesses, an IRS tax audit could ensue.

Jamie Johnson contributed to this article.