Remove the bullseye: Prevent a small-business tax audit – with an audit

Because small businesses typically receive much of their income in cash and may receive few or no information statements, the IRS sees them as likely candidates to underreport income. According to the IRS tax gap study, 63 percent of income subject to little or no information reporting was misreported. This makes small businesses a prime target for IRS audits. To lower the chances of an audit and prepare to defend a tax return in the event of an IRS audit, small businesses should conduct their own informal audit.

Self-audit step one: Check the bank account

One of the IRS’s first tests in an audit is to analyze the small business’s bank accounts to ensure the bank deposits match total revenue reported on the return. Significant, unexplained deposits would signal possible unreported income to the IRS.

If these amounts are, in fact, income, the small business must report that on the tax return and pay any applicable tax.

“But if the deposits are not income, the small business should organize and prepare documentation showing the source of the deposits and why they aren’t income,” said Nathan Rigney, lead tax research analyst at The Tax Institute at H&R Block. “This could include loans or sales tax collected for state or local governments.”

It is also recommended that small-business owners not mix business and personal transactions. To that end, they should have separate checking accounts, credit cards, etc., for business and personal use.

Self-audit step two: Check debit and credit card payment records

The IRS uses Forms 1099-K for debit and credit card payments to identify income that should be reported on business tax returns. If a small business records credit card sales in its accounting system, it should reconcile total credit card sales to Forms 1099-K at the end of the year. Alternatively, the IRS could compare the amounts received from merchant card transactions to its sales by month. Monthly inconsistencies in the proportion of card transactions to sales could trigger a second look.

The IRS also does a trend analysis for many types of businesses, comparing income reported with Form 1099-K from similar businesses. For example, suppose a certain kind of retail business typically reports 40 percent cash income and 60 percent credit card income, and the IRS has these statistics. If a business’s return shows $100,000 of income, $95,000 of which is reflected on the Forms 1099-K, the IRS might suspect that the business is underreporting its cash income.

“Discrepancies between a small business’s reported income and the amounts on its Forms 1099-K do not necessarily mean a small business is misreporting income. A discrepancy could result, for example, when Forms 1099-K double report information on Forms 1099-MISC,” said Rigney.

In these cases, small businesses should examine any inconsistencies to identify the cause and either resolve it on their tax return or prepare documentation to defend the return against an audit.

Self-audit step three: Check those deductions and credits

Small businesses may be eligible for certain deductions and credits that may require additional supporting documentation. A home office, business use of a car, employees’ pay and other operating expenses can add up to significant tax benefits, and all of these items must be well-documented and substantiated.

Small-business owners should not only keep records of their business expenses to support their deductions and credits, but they also should double-check their eligibility for the tax benefit. For example, the home office deduction requires exclusive use of the space for business purposes. If business owners also use a home office for personal reasons, such as using the office as a spare room for guests, they may not claim the home office deduction.

Self-audit step four: Get professional help

Many small-business owners may not have the time or expertise to prepare their own taxes, let alone audit their own return. Getting assistance from a local tax expert who specializes in small business returns can help lower their risk of an audit, which, in turn, can lower their risk of costly penalties.

If the IRS examines a small business return and finds misreported or underreported income, the IRS could pursue accuracy penalties. Significant amounts of unreported income or overstated tax benefits can result in a more expansive audit and the potential for the IRS to pursue civil or criminal fraud allegations. Small business tax experts can help the owner “measure twice, cut once” and file a complete and accurate return that can stand up against an IRS audit.