Legitimate Mistakes
The current tax filing system is not intuitive, and it's very easy to make mistakes. Sometimes the IRS will flag your account just because you've made a simple mistake on your social security number or made a mathematical error. In some cases, the IRS will only focus on this error and not require a full audit. But if other triggers are present, the IRS may insist on a full review of your business to ensure that there's nothing else that's been misstated. Always double check your tax forms to make sure that the information is correct. Having another person whom you trust, or a software program that performs the check for you, can be very beneficial to avoid an IRS audit.
Continuous Schedule C Losses
When you're running a sole proprietorship or partnership, you can sometimes claim your net losses to offset your tax payments or save them for the following year's deductions. However, if you continue to claim net losses without net profits, the IRS will take notice. As a general rule, the IRS allows you to claim net losses three out of five consecutive years. That doesn't mean that they won't come check your business out before that time, but if you exceed five consecutive years of schedule C losses, you'll wind up with an IRS audit and potentially a loss of your business deductions, among other penalties. If you can't make a profit, this usually results in the IRS treating your business as a hobby rather than a business.
Excessive Expenses and Business Deductions
In general, business deductions and expenses won't get you flagged, but excessive expenses for luxurious items or items that are clearly unrelated to your business will come back to bite you. Travel and meal expenses tend to get the most attention from the IRS, as do luxury items like televisions, exercise equipment, videogame consoles, and other similar items. Often times, business owners try to use business expense claims to offset their own personal expenses, which can be very bad for your business. To protect yourself, save your receipts and document why they were valid business expenses. If, for instance, you are entertaining a client, write down the client's name on the receipt as well as the purpose. Otherwise, when you get to the point of an audit, you might not be able to remember why it was related to your business. This, and of itself, can be quite stressful.
Failure to Pay
The IRS tries to monitor and cross-reference all accounts it receives. So even if you don't report income, your client might report it, and then the IRS will notice that you didn't report it. This results in a significant flag, particularly if it exceeds $300. Additionally, if you fail to pay your taxes at all, the IRS will likely come knocking. Similarly, the IRS may show up for an audit if you don't actually pay enough on your estimated taxes. Generally, your business needs to pay at least 90 percent of all estimated quarterly taxes by the end of the year. Otherwise, you'll wind up with a penalty and possibly an audit. It's uncommon for businesses to be audited simply because they failed to meet quarterly payments (so long as they fill out Form 2210) but even then it's not a guarantee.
Getting audited by the IRS can be nerve-racking, but if you know how to avoid the red flags, you significantly reduce that likelihood. Be cautious when filling out your taxes and be meticulous with record keeping. Although you can't completely eliminate your risk of an IRS audit, these precautions can help reduce your chances of getting singled out by the IRS.
If you do get selected for an audit, it's smart to talk to a tax lawyer.
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.
