Many small business owners find tax season to be stressful. Filing taxes can be even more stressful when you consider the potential of an audit. The Internal Revenue Service (IRS) announced in late 2020 that it planned to increase the percentage of small business audits by 50%. While your chances of being audited are still relatively low, it is still a good idea to ensure that your books are in order to reduce your risks in case you are selected. Here is some information from TMD Accounting about how far back the IRS can go if it decides to audit your business.
How Far Back Can The IRS Audit You?
The general statute of limitations for an IRS audit is three years under 26 U.S. Code § 6501, which means that the IRS can audit your tax returns for the most recent three years. However, there are multiple exceptions to this general rule. For example, if an auditor determines that you have made substantial errors on your returns, they can add more years to the scope of the audit. According to the IRS, it will generally not go back more than six years unless the agency suspects that you might have committed fraud or have failed to file your required tax returns.
Statute of Limitations on IRS Tax Audits
As previously noted, the IRS generally has a three-year statute of limitations for tax audits from the date you file your return or the date that it is due, whichever is later. For example, if you file your tax return early, the statute of limitations will run from the due date rather than your filing date.
If you substantially understated your income, the statute of limitations for an audit is six years. A substantial understatement of income occurs when you omit 25% or more of your income. If you failed to file a tax return, the IRS will not have a statute of limitations to audit you since the time period will not start running until a return is filed. Similarly, if you filed a fraudulent return, the IRS can go back and audit it regardless of how long ago it was.
What Triggers an Audit?
In a majority of cases, the IRS chooses returns to audit randomly. However, the following red flags can increase the likelihood that you will be audited:
- Failing to report all income
- Being a high-income earner
- Claiming a large charitable deduction
- Making calculation errors
- Claiming excessive deductions
- Filing schedule C as a self-employed taxpayer
- Claiming the home office deduction
- Claiming deductions for business travel, meals, and entertainment
- Claiming that a hobby is a business
- Claiming you used a personal vehicle 100% for your business
- Claiming the Earned Income Tax Credit (EITC)
The IRS distinguishes between businesses and hobbies by using a standard for profitability. If your business was profitable for three out of the past five years, the IRS will likely consider it to be legitimate. If your business claimed losses for three of those years, the IRS might consider your business a hobby and select you for an audit.
Tips For Avoiding Tax Audits
Here are some tips for avoiding a tax audit.
- Avoid Reporting Net Annual Losses
Reporting small net annual losses for your business can trigger an audit. While you have to report all of your income, you are not required to report all of your expenses. It might be a good idea to leave some of your expenses out if doing so will allow you to report a small net profit.
- Specify Your Expenses
As much as possible, avoid categorizing your expenses under “other expenses” on your return. Instead, explicitly list each expense by itemizing them.
- Provide Additional Detail as Needed
If you had a major drop or increase in a category of expenses, you should attach additional paperwork to your return to explain what happened in detail. This might help to answer questions an IRS agent might have about the sudden changes if your return is triggered.
- File Your Returns on Time
Filing your returns and paying your taxes on time shows a history of compliance. This might help to avoid a potential audit. You should also try to avoid amending your returns to help establish your history of compliance.
- Double-check Your Paperwork and Math
Make sure that the numbers on your forms match what you report on your return. You should also double-check your calculations to ensure that you have not made any math errors. The numbers you use for deductions should also vary from year to year. Don’t claim the same numbers for your deductions from year to year.
- Avoid Claiming Excessive Deductions
Don’t claim excessive deductions by overestimating your donations, meals, travel, or home office expenses. If you claim excessive amounts on your deductions, your return could be triggered for an audit. Similarly, claiming many deductions you haven’t claimed before can also make it likelier that your business return will be audited.
- Don’t Leave Blanks On Your Tax Form
You should answer every question on your tax form, including those for which your answer is $0. Leaving blanks could result in an oversight that triggers an audit.
How Do I Find an Accountant for My Small Business?
Working with a qualified accountant to prepare your business tax returns can reduce your chances of being audited since your returns should be fully accurate. While there will still be a chance that the IRS will select your business’s tax returns for an audit, having the help of the small business accounting services at TMD Accounting can help you to achieve a better outcome if you are audited. Call us today for a consultation at 1-856-228-2205.