Audits of a business can be conducted by the Internal Revenue Service (IRS) or the Florida Department of Revenue (DOR). A very small percentage of companies find themselves audited each year, so it can be shocking and frightening if you are one of the small businesses selected. Many business owners ask, “Why would my business be flagged for a tax audit?” It is crucial to understand why IRS audits happen, the tax audit laws involved, and how to mitigate the risk of being audited.
Why Do IRS Audits Happen?
In Fiscal Year (FY) 2024, the IRS assessed more than $7.7 billion in additional taxes through the Automated Underreporter Program. The IRS also assessed $29 billion from tax return audits, and nearly $9.5 billion of those assessed taxes were from individual income tax returns. Audits can result in increased tax bills or even criminal charges. In FY 2024, the IRS initiated nearly 2,700 investigations through the Criminal Investigation Program.
The IRS conducts audits for three primary reasons:
- Random selection: Your business was randomly selected for an audit.
- Computer screening: Your tax information was compared to norms for your type of tax return or other related financial information, and a discrepancy was found.
- Related examinations: Another taxpayer was selected for an audit, either for-cause or through random selection, and this taxpayer is a business partner, investor, or another party with which you have transactions.
Both human and computer processes are used to determine when audits are necessary. Just because you are being audited, it may not always indicate an issue.
However, if you avoid errors or red flags in your tax information, you can limit the chances of a discrepancy being found, which can lead to an audit. While this doesn’t eliminate the possibility of ever being audited, it can significantly reduce the likelihood of one.
Issues That Can Lead to Audits
Several financial situations, statistical anomalies, and other errors can draw the attention of the IRS and cause an audit of your business. Tax audit cases commonly involve:
1. Misreporting Business Income
Failing to report all your income is one of the biggest triggers that can lead to your business being flagged for an audit. This can be especially difficult for businesses with numerous income sources, but that makes it even more important to be careful. Misreporting income for your business may include:
- Stating a higher-than-average income for your company or field
- Rounding up numbers
- Averaging the income you earned
- Failing to report some sources of income
The IRS will compare tax forms to the amounts listed on your return. Missing income or amounts will likely lead to an automatic audit.
2. Excessive Expenses or Deductions
A business’s expenses will often change each year, but drastic differences are considered red flags. Sudden excessive business expenses in one year will likely lead to an audit.
Excessive deductions can also increase the chances of an audit. Business owner itemized deductions often include travel costs, internet, and home offices. If your business has more deductions than other businesses of your size and in your industry, this can trigger an audit. A deduction must be a legitimate business expense that is either an ordinary expense or a necessary one. Be sure you know the difference between a business and a personal expense.
3. Repeated Business Losses
Business losses happen, but claiming a business loss each year on your tax return is likely to cause an audit. If you file for business losses multiple years in a row, it’s important to document your income and expenses properly.
4. Significant Cash Transactions
Cash transactions are especially common in restaurants, salons, and other tip-reliant industries. Any small business with significant cash transactions is more likely to face audits, even if cash transactions are common in the industry.
5. Employee Misclassification
When employees are misclassified as independent contractors, this takes many obligations off an employer that the employer is meant to have. Because of this, working with independent contractors as a business owner increases the chances of an audit, as the IRS may want to determine if they are properly classified
6. Late Deposits or Returns
If your deposits for payroll taxes are frequently filed late, this can lead to an audit. Filing late or failing to file altogether can also result in other serious financial penalties.
FAQs About Business Flagged for a Tax Law
What Triggers an IRS Audit for a Small Business?
When an IRS audit is for-cause to review a small business’s tax filings, it could be triggered by errors like:
- Employee misclassification as independent contractors
- Excessive and repeated business losses
- Misreporting income
- Excessive deductions
- Excessive expenses
- Filing deposits late
- Significant cash transactions
- Large charitable donations
However, IRS audits can also be random, or they might occur because you do business with another party that was audited. While you can take steps to limit the chances of an audit, one may still happen.
How Likely Is a Business to Get Audited?
The likelihood of a business being audited is low. In FY 2024, 0.2% of corporate income tax returns were examined, or audited, by the IRS. Companies with high incomes tended to have a higher percentage of audits. Other types of business audits, such as those of partnerships, S corporations, and employment tax returns, each had an examination rate of less than 0.05%. Information errors or late returns increase the likelihood of an audit.
What Does the IRS Look for in a Business Audit?
The IRS looks to determine if the information a business provides on its tax return has been accurately reported, verifying that the correct amount in taxes has been paid. The IRS may examine records such as:
- Receipts for products and services
- Bills for services rendered
- Canceled checks
- Court information, such as:
- Property division settlements
- Other settlements in divorce
- Tax preparation advice
- Civil defense papers
- Loan agreements and the loan’s use
- Business trip travel tickets
- Medical records
- Theft reports
What Are the Consequences of an Audit?
An audit can result in you being required to pay a greater amount in taxes. It may even lead to criminal consequences if the IRS has reason to think you deliberately avoided paying taxes. However, an audit can also result in no issues being found and, therefore, no changes to your tax bill. If the IRS agent finds an issue and you disagree with their findings, you could also appeal the decision.
Hire a Tax Audit Lawyer in Florida
If your Florida business is being audited, you need a tax audit attorney to assist and represent you. Contact TaxSmith, LLC, today.
