5 IRS Categories’ Audit Risk for Small Businesses

business Entity type 8

It is very stressful when find yourself under the IRS microscope. Here are 5 categories that impact audit risk for small businesses according to the IRS commissioner.

The best course of action: Retain all receipts and other tax papers (even if scanned into your smartphone or desktop), conscientiously record income and expenses, and work with a certified professional accountant.

Highlights:

  1. Entity type
  2. Income level
  3. Location
  4. Deductions
  5. Type of business

Entity type

business Entity type

From a legal standpoint your business entity impacts your IRS audit risk. Statistics in the 2014 IRS Data Book show that an S corporation or partnership (including a limited liability company filing a partnership return)—regardless of income or other factors—had only a 0.4% chance of being audited in the government’s fiscal year ending September 30, 2014. In contrast, a sole proprietorship with gross receipts between $100,000 and $200,000 had a 2.4% audit risk (or 6 times as great as the other pass-through entities).

What will you do if you operate your business as sole proprietorship?  It’s important to recognize that being a sole proprietor places greater need on owners to maintain good books and records and follow tax rules.

Income

The amount of gross receipts (fees, sales receipts, and other earnings before any deductions) impacts the audit risk of sole proprietorship. Here’s what the Data Book shows for the government’s 2014 fiscal year:

Gross receipts Percentage of returns audited
Under $25,000 1.0
$25,000 to under $100,000 1.9
$100,000 to under $200,000 2.4
$200,000 or more 2.1

If you’re a sole proprietor, you should simply put on the alert to use good business practices as protection in case of audit.

Location

IRS offices are staffed differently in various locations across the country, enabling some offices to conduct more audits than others. There is no current data on how this impacts your audit risk (in prior years, certain districts such as Manhattan, NY, and Houston, TX were known to have higher audit risks).

Again, should you relocate to a place with little or no IRS coverage? No. Just be prepared to face an audit, use good business practices by carefully tracking your income and expenses and use certified professional accountant.

Deductions

The type and amount of deductions claimed can flag a return for audit. Because travel and entertainment expenses deducted for business may arguably be more personal in nature, the IRS looks carefully at these write-offs to make certain they are legitimate and that they have been adequately substantiated.

Also IRS computers are purported to select returns of businesses that take unusually high deductions relative to their income. (One government agency reported back in 2004 the average expenses for sole proprietorships.) Once selected, an agent may look a little more closely before deciding whether to commence an examination. This may simply be asking for substantiation of deductions claimed on the return (a process that can be done by mail or phone).

Please note businesses should take every deduction to which they are entitled. However, they must have required documentation and records (e.g., receipts, logs) for these business deductions.

Type of business

Cash businesses are suspected of omitting income because they can; there is little or no paper trail. In fact, cash businesses are said to be a large part of the more than $450 billion tax gap. The tax gap is the spread between what the government thinks it should collect and what it actually collects.

There is an IRS audit guide specifically for cash intensive businesses (e.g., beauty shops, car washes, laundromats, and many other types of small businesses), which instructs agents about what to look for during an audit. Cash businesses should review this guide to learn what they can do to create audit protection, just in case they are selected for examination.

Conclusion

business Plan

There are no statistics or other evidence to show taking a home office deduction is an audit red flag.  According to the Small Business Administration (SBA), 52% of all businesses in the U.S. are home-based, so it’s not likely that the IRS is going after every one of them.

The conclusion that your business is at IRS audit risk under any of these or other categories.  The best course of action: Retain all receipts and other tax papers (even if scanned into your smartphone or desktop), conscientiously record income and expenses, and work with a certified professional accountant.


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  1. 2014 IRS Data Book
  2. IRS audit guide

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