The word "audit" comes from the Latin word "audire," which means "to hear." In fact, it is the tax authorities "hearing" your business's financial records. No men in black suits with earpieces are knocking on your door, and no files are being taken out of filing cabinets.
Once you know how they work, audits are more of a hassle than a scary thing. First, we'll talk about that. Then, we'll talk about how to avoid being audited and how to make the process go more smoothly if it does.
When the IRS does an audit of your business, they look at all of your financial records in detail. This means going over your financial statements and making sure they match up with your bookkeeping. Most of the time, they want to make sure you don't understate your income or overstate your deductible expenses. In either case, you are saying that you owe less tax than you actually do.
It is almost impossible to know when an audit will happen. But they are set off by one of these three things:
- Taking unusually large deductions, such as deducting your personal car use in full. You could face tax evasion charges.
- Misclassification of employees
- Non-filing of information returns (W2s, 1099s, and so on).
- Failure to report taxable crypto activity may result in penalties, interest, and even criminal charges. It may be considered tax evasion or fraud.
In the movies, a bunch of IRS agents bust through your door and raid your office. Your business partner flies on a private jet to the Bahamas. Your bookkeeper goes to the bathroom. Your secretary is no longer working there. In real life, this is not what an audit looks like. (The IRS may do a field audit, though, if there are special circumstances.)
1) Correspondence audit. The IRS will contact you via email or postal mail to request additional information. This is usually due to an income omission or another serious error. You must either pay the amount specified in the correspondence, file a legal challenge, and/or provide the necessary documentation, such as deduction receipts or missing W2 forms.
2) Office audit. The IRS may request an in-person interview with you. You will have to go to the IRS office. It's a good idea to bring along a CPA or a lawyer. If you contest it, you may end up paying more in taxes or penalties, or you may not have to pay anything at all.
3) Line-by-line audit. This was chosen at random. The IRS scrutinizes every line of your tax return to determine the "norms" that will trigger future audits.
But don't be concerned about it. You will be in the clear as long as you cooperate (or legally contest), offer sufficient evidence when it is necessary, pay the fines, and demonstrate that you did not act with criminal intent.
You can never be sure that you won't be audited. But if you do the following, you can cut your chances of getting one by a large amount.
Using the information on Forms W2, 1098, and 1099, the IRS compares the income and deductions you report on your tax return with the information reported by others, like your employer, bank, or business. For the IRS, a big red flag is a difference between how much income was reported and how much tax was paid. It almost certainly means that more research needs to be done. So, if you do consulting or freelance work on the side, even if you think you can get away with not reporting it, you should.
One of the simplest ways to ensure a visit from the tax man is to make a careless mistake on your tax return. If there are any omissions, miscalculations, or errors on your tax return, the IRS is required to conduct an additional investigation. Hire a bookkeeper to ensure that your books are accurate and ready for taxation.
Vincere Tax not only does your books, but can also file your taxes for you. If you want to speak with a tax professional, click here.
You can choose between cash basis accounting and accrual accounting as a business owner. If you switch back and forth between the two methods, the IRS may think you are trying to throw them off. At that time, you will be checked out. Make sure that your business's accounting method is consistent, no matter what it is.
When hiring help, you must determine whether the workers are employees or independent contractors. This distinction determines which taxes must be paid, when they must be paid, and who is liable for them. Employees are usually required to pay income taxes as well as unemployment, social security, and Medicare taxes. You are not required to withhold or pay taxes on the income of an independent contractor.
The IRS has three years from the date you file your tax return to audit you for that tax year. There are, however, a few exceptions:
If you fail to report more than 25% of your gross income, the IRS can audit your federal tax return for up to six years. This also applies if you pay the same amount as if you had underreported 25% of your gross income through other means.
The IRS statute of limitations is extended to six years if you fail to report $5,000 or more in foreign income, such as cash held in an offshore account.
The statute of limitations runs indefinitely if you own stock in a foreign corporation and fail to report it on Form 5471. That means the IRS could audit you for any tax return you've ever filed.
The statute of limitations is indefinite if you have never filed taxes or if the IRS determines that one of your returns is fraudulent. This fraud penalty may apply even if you made an honest mistake, such as forgetting to sign your tax return or inadvertently changing the "penalties of perjury" text at the bottom of the form.
No one likes to think about what could go wrong. But if you do the right things now, a future tax audit will be less painful.
If you keep your small business records in order, it will be easier and faster to support anything the IRS asks for. The IRS often looks into what makes a hobby different from a business. The IRS says that if you do something that is not a business, your "allowable deductions cannot exceed the gross receipts" of that activity. In some places, this is known as the "hobby-loss rule." Keeping accurate books and using financial records to back up your claimed profit margin will help show that you are running a real business and not, say, claiming tax deductions for your personal macramé workshop.
The IRS says that business owners need to keep their personal finances separate from their business finances. Unless your business is a sole proprietorship, you are required by law to keep your business expenses and your personal expenses separate.
When you add up costs together, you see through the corporate veil. This means that if your business owes money, creditors, like the IRS, can take your personal property.
If you are currently putting both business and personal expenses in the same account, you should open a small business bank account as soon as possible to separate them. If you keep all of your business expenses in a separate bank account, it will be much easier to deal with a tax audit. This is because it creates a legal wall between your personal and business assets.
So let’s say, when you filed your taxes, you made a mistake. It could have been found out during an audit, or you could have forgotten about it during tax season and been late. No need to worry! If you didn't mean to do anything wrong, you probably won't go to jail or lose your small business.
Taxes not filed on time - First of all, you can always ask for more time to pay your taxes. If you file your taxes more than 60 days after the due date or the date you were given an extension, you will have to pay a minimum penalty of $205, or 100% of the amount you owe if it's less than that. This is true only if you file before the deadline of 60 days. If you don't file for the following months, you'll have to pay a fine of 5% of the unpaid tax each month. You should still file your taxes and pay what you can, even if you know you won't be able to pay the whole bill. Interest from the IRS can quickly add up.
Late payment of taxes - You must pay an additional 0.5 percent of unpaid tax each month until you have paid off your entire tax bill, up to a maximum of 25% of your total tax bill. Keep in mind that this penalty applies even if you sent in a check on time but it bounced.
Penalty for both late filing and late payment- Fortunately, these two penalties are not cumulative. If you are late on both, you will only be charged 5% interest per month.
Paying your taxes late after receiving a Notice of Assessment- If the IRS discovers that you owe more taxes than you previously believed, they will send you an Issuance of Notice requesting the additional payment. After that, you have 21 calendar days to pay the extra amount, or 0.5 percent interest per month will begin to accrue.
Late submission of a form- Failure to return a W2 (for employees) or a 1099 (for contractors) results in a $50 fine.- Failure to return a 1065 form (for partnerships) or a 1120S form (for S-Corps) on time will result in a fine of up to $195 per month per partner.
Incorrectly calculating your owed taxes: If you significantly underestimate how much tax you owe, or the IRS determines you were negligent in an aspect of your taxes (i.e., it wasn't a minor mistake), the penalty is a 20-40% increase in taxes owed.
Employee taxes are being calculated incorrectly: There is a 100% penalty on all unpaid federal employee taxes. In other words, if you don't pay employee taxes the first time, you'll have to pay them twice. Failure to report employee wages through your payroll provider and failure to report employee tip income are the two most common scenarios.
When is something considered illegal?: If the IRS determines that your error was more than carelessness and that you lied, filed a false return, or purposefully violated tax laws, you have broken the law and may lose your property or face jail time. The IRS is not playing games.
Vincere Tax can help you figure out how your business taxes, stocks, bonds, ETFs, cryptocurrency, rental income, and other investments will affect your taxes. It's like being hit by lightning to have to go through an audit. Even though it's not likely, you shouldn't practice pole vaulting in a storm. One of the best ways to keep your head down during tax season is to make sure your books are correct and your taxes are filed on time.
Talk with the team at Vincere Tax to ensure you are taking all the right steps to avoid or get you through a tax audit!
To make that goal a reality, talk to an advisor Vincere Wealth to get that ball rolling!