No one wants to be audited. It’s just too much hassle for one person to undergo. To be fair, according to CNBC, only 0.7 percent of tax returns are ever audited. It’s too much of a hassle to be audited. You have to focus on the business, but having to prepare documents and calculating numbers are time away from your business. These activities will take your focus away from the business. So prevent a tax audit at all cost.
Why do companies or businesses get audited? The red flags?
All types of income should be reported, whether it’s your regular income or a side hustle. There is a bit of a trend with the Internal Revenue Service (IRS): The more income you earn, the more likely you are to be audited. Of course, if everything is just in order, there will be no chance of you going through an audit. This is why you have to report all kinds of income. If it’s money you earn from a job, then it better be recorded in your tax return.
The IRS is the biggest tax collection agency in the world. It is serious about its job. So don’t be surprised why this agency knows about hidden incomes that have not been reported. It has the resource to check records—so just don’t even try to circumvent tax rules. Aside from merely looking at your tax returns, the IRS has the tools to go over your financial records and even bank accounts. If it notices discrepancies in your records—like you have too much money in the bank compared to official records of our earnings— then you are likely in trouble. The wider the discrepancy, the more the IRS will look into your record.
A tax audit is just the process wherein the IRS scrutinizes your records. But it’s really the penalties that are the real thorn in your life. A minimum penalty of five percent per month will be imposed in the calculated tax of your unreported income. And if you opt to pay for the taxes in installment basis, interest will also be imposed until such time every cent has been paid off.
Expenses for business owners could be tricky because there are many expenses that don’t have receipts. So if you report a lump sum amount in your tax return as an expense without breakdown and without receipt, then chances are you will get under the radar of the IRS.
According to a report, between 2008 and 2010, unreported tax amounted to $458 billion. Of this amount, 60 percent came from business and self-employed income.
This is why it is important to keep receipts and everything should be documented. Since there are some cases where there really are no receipts available, then at least make a business log of expenses you have incurred. Of course, expenses should be related to the business that you run.
Why keep bank accounts from another country when American banks are perfectly capable of securing your money? And that’s why it is a red flag for the IRS if you have overseas accounts. But if you do have an overseas account, you have to report it—especially if the amount is $50,000. There is a Form 8938 where you can report such account. But this form is different from the Foreign Bank and Financial Accounts report, which is necessary for Americans who have overseas bank account with over $10,000. This report, though, doesn’t go into the tax return, which is why there is a separate form for tax purposes.
There are tax benefits to having rental properties. But the advantages are really attached to your profession—if you are a real estate professional, that is. The advantage is that if you have rental losses, these can be deducted to unrelated income. But real estate doesn’t have to be your full-time job to enjoy this benefit. It could be a side hustle and you will enjoy this advantage. However, if you do put rental losses in your tax return, the IRS will look into it. That’s why you have to prove that real estate is something you do. You need at least 750 hours a year working on real property to justify real property experience.
Multiple net losses
If you report losses year after year then that’s a red flag. Didn’t you learn from the first year you experienced a loss? You are most likely to be audited if you report losses in two years out of the five years your business is in operation. You are even more at risk if you operate a sole proprietorship. This is because with sole proprietorship, there is no delineation between personal finances and the business. So when you report a loss, believe that the IRS will have a second look at your return and finances. To prevent this, just make sure that you aren’t being excessive with your spending, because if you are, the IRS will have something to blame those losses on.
Consistently filing late tax return
Filing a late tax return is already a red flag, but if you do it more than once, then that’s definitely a cause for an audit. When it comes to the IRS, you have to fly under the radar. When you file a late tax return, that’s not exactly going under the radar. In order to prevent getting late, you have to record expenses that could be reported in your tax return. This way, when it’s time to file your tax return, you just go to your record and list them down.
Salaries that are too high
So if you own a business along with some other investors, there is a chance you will give you and the others high salaries. Don’t be tempted to do so because this is bait for a tax audit. As earlier mentioned, the more money you earn, the more chances you have of being audited. To prevent this kind of problem, you have to know the base salaries of the kind of job you and the others do in the business.
Too many deductions
Choose the deductions that you will record in your tax returns. Deductions are necessary and they are totally acceptable, but having too many of them will of course raise the red flag. Deductions should always be related to the business you run. Travel and meals are usually acceptable, just be careful that you don’t overdo it. One way to get away from the IRS’ senses is to be consistent with your deductions over the years. You may increase them but it has to be at par with the growth of the company. Basically deductions just need to be justified.
Giving too much to charity
Yes, giving to charity is good. But sometimes, giving too much is suspicious. Charity is usually what taxpayers use to get away from paying too much tax. That is why it is prone to abuse. And over the years, the IRS has smarted up. That’s why giving too much to charity is a red flag, so just give enough.
Excessive business vehicle use
There is such a thing as an IRS standard mileage rate. The following is the standard according to the IRS website:
- 54.4 cents for every mile of business travel
- 18 cents per mile driven for medical purposes
- 14 cents per mile driven for charitable organizations
This is why you cannot possible claim 100 percent business use of a vehicle. But if you don’t use this standard mileage system, you can use the actual expense. However, you cannot use both the official mileage rate and actual use of the vehicle. Doing so would put you in the IRS radar.
By the way, here are business-related activities that would merit deduction for tax purposes:
- traveling to meet a client
- traveling for research
- traveling to post mail for business
- traveling for other business-related dealings
Too much cash transactions
No American holds too much cash in the pocket—that’s usually something mobsters do, or those who are up to no good. So of course the IRS will not think too highly of you if you spend too much using cash transactions. The reason why this is frowned upon is because income made through cash is hard to verify. But if you have to pay in cash, just make sure the recording is precise and detailed.
It’s easy to assume that if you are just a small business owner, you have a small income and will be safe from audit. That is usually the case, the trend—but it’s not a black and white thing. You could have a low income but if you still have a record of red flags as stated above, then the IRS will still be scrutinizing you, your tax return and your finances. The most important thing is that you don’t do anything out of the ordinary that will get the attention of the IRS.