Many business owners might not suspect it, when the Internal Revenue Service (IRS) conducts business audits, it doesn't just examine your business -- it puts the owner under the microscope as well. Unsuspecting business owners can get caught in uncomfortable situations during audits where they end up having to justify their personal as well as their business expenses.
What the IRS is Evaluating
Here are some of the most common things that IRS agents are trained to look for during business and personal audits.
- Does your lifestyle match your income: If your tax returns report little income and a lot of deductions, yet you drive a really nice car and wear fancy clothes, IRS agents will dig deeper. The bottom line is, if your tax return doesn't seem to match up with your lifestyle, expect to get a lot of questions about your personal expenses.
- Do you claim a lot of personal entertainment expenses as business expenses: A lot of small business owners fudge on mixed personal and business expenses, and the IRS knows this. If you've claimed a significant amount of entertainment, meals or vacation costs as business expenses, expect the IRS to be extremely skeptical. Just saying you took someone out to dinner for business doesn't cut it. The IRS will want some sort of documentation corroborating that the excursion was indeed business-related.
- Do you have a lot of auto expenses: Many small business owners only have one car that they use for both personal and business trips. If you claim a lot of auto expenses as business-related, you'd better be able to back it up with mileage logs and receipts.
- Do you have a lot of miscellaneous expenses: When you are filing your taxes each year, it's best to avoid listing expenses as miscellaneous if possible. A significant amount of miscellaneous expenses is a red flag for the IRS because it indicates that either you keep poor records, you are sloppy, or you are hiding something.
- Does your business handle a lot of cash: If your business is largely cash driven, IRS agents are taught to assume that you are skimming or diverting money into your own pocket. Again, the better your receipts and logs are, the better off you'll be.
- Does your business use independent contractors: Many businesses hire what they call "independent contractors" to avoid paying payroll taxes, but those independent contractors are really employees. Expect extensive questioning about the role of these employees: who they answer to, who directs them, how much freedom they have, etc. If the IRS decides that your independent contractors are really employees, you will get hit with some serious back taxes and penalties.
- Did you fail to report some business income: if an IRS agent gets the impression that you simply "forgot" to report certain items as income (usually $10,000 or more), then you might be in very serious trouble. Purposefully not reporting income is criminal, and the IRS maintains a special criminal team that it uses during audits. If this ever happens, hire a specialist in tax audits immediately, remove yourself from the process and let the audit take its course.
- Do your payroll taxes match your reported employees: If you are using employees rather than independent contractors, make sure that their payroll taxes are complete and accurate - the IRS will be double checking your payroll taxes to ensure that they match your claimed employees.
Consider Hiring an Attorney to Assist in Audits
Don't worry that hiring a professional may give some indication of guilt; the IRS is used to it, and in many instances might prefer dealing with a professional familiar with the process. If you're feeling anxious about any of these potential items, consider hiring a business and commercial attorney or a tax professional to help you through the audit.