What are the Top Reasons for an IRS Audit?
What is an IRS Audit?
An IRS audit is a thorough inspection of the financial records of your business. It is the process through which the IRS evaluates your tax filing records.
The IRS may need proof of transactions reported by your business to claim tax deductions, credits, and donations.
The IRS process starts with a formal letter requesting you to send some documents and records. During the process, you may use a CPA to represent your business against the IRS.
What are the Top Reasons for an IRS Audit?
The IRS can audit a business for various reasons. It can detect tax errors, wrong income, oversized deductions, and mixed personal and business expenses.
Sometimes your business may get audited during the random sampling process of the IRS as well.
Here are a few top reasons why the IRS may audit your business records.
Hiding the Actual Business Income
For any reason, if you underreport your business income, you’ll get caught by the IRS. Most businesses fail to report all income sources in one place.
Sometimes, business owners mix up their personal and business income. Others fail to report foreign or passive income that comes under the umbrella of the business income.
Since your business and your clients report the same transactions to the IRS, you have no escape but to report the full business income.
Taking Undue Tax Deductions
Tax deductions come with limits. It means you can deduct a certain expense up to a maximum limit per tax filing period.
A common mistake made by business owners is to overwhelmingly deduct full expenses like travel, home office expenses, etc.
You can deduct as many items as allowed but keep them to the allowed limits.
Claiming Too Many Donations
Charity donations and expenses incurred for registered social welfare organizations are allowable tax expenses.
You can deduct charity donations up to a certain limit every year. It means if you going overboard with donations, you’re creating a red flag for the IRS.
Also, you’ll need to keep receipts and records for all donations.
Having Too Much Cash Transactions
Cash businesses are more likely to get an IRS audit anyway. Many cash businesses fail to keep proper records or report false income tax figures to the IRS.
If your normal business activities do not involve too much cash but you are still reporting a lot of cash on your tax returns, it is a red flag for the IRS.
Suppose your business had been earning an income of around $15,000 annually for the last few years on average.
Suddenly, you see a sales hike, and your profits jump to $30,000. While there is nothing wrong with it, the IRS may want to see proof of income for this anomaly.
Reporting Business Losses Consistently
This is a mistake made by most small businesses. They make accounting adjustments like depreciation expenses to lower their taxable profits.
As long as you report genuine business losses and keep a record of them, you have no issues. However, if your personal wealth is growing or you are spending a lot and your business keeps making losses, it will trigger an IRS audit for sure.
Excessive Entertainment and Travel Expenses
Along with other excessive deductions, entertainment and travel expenses are common ones. Many business owners make a mistake by deducting the full amount of these expenses from their business income.
You are allowed to deduct travel expenses using the mileage cost and limits set by the IRS. Similarly, your business entertainment expenses should be only for business purposes and backed by receipts.
Mixing Personal and Business Expenses
Businesses with a pass-through entity structure should be careful with this common mistake.
Many business owners mix their personal and business expenses. The business and personal income tax rates are different, so claiming personal expenses as tax deductions for a business means trouble.
Reporting Too Much or Too Low Income
Like anomalies, businesses may report a too high or too low income figure suddenly. Although, there is nothing wrong with it as long as you can back the claims with proof.
The same goes when you start showing too many losses suddenly. The IRS would require documented proof if you have a genuine reason for reporting abnormal income or losses for a given year.
Errors on Tax Forms
Finally, if you have a few small mathematical errors on your tax returns, the IRS will correct them. However, if there are too many calculation errors or wrong deductions without apportioning them, then it may get you an IRS audit call as well.