3 Common Mistakes That Lead To Tax Audits

Many small businesses fear an IRS audit. Here are the three best ways to avoid one.
President and Founder, Big Ideas for Small Business, Inc.
March 13, 2013

There’s no way to completely audit-proof your return, but you can definitely make some mistakes while preparing your return that could trigger audits. What’s more, there are things you can do to protect your tax positions in case of an audit. Here are some practical actions that can help you steer clear of these common mistakes and protect your tax positions.

1. Don't Misreport Income From Information Returns.

If you receive 1099s and Schedule K-1s reporting business income, be sure to pick it up on your return exactly as it is reported to you. The IRS’ computers easily detect underreporting of income that’s reported to the IRS, automatically triggering an audit. (The audit may be nothing more than a letter describing this reporting error and asking for additional taxes resulting from your underreporting, but you can avoid the letter by proper reporting.)

Likewise, be aware that some filings virtually invite an audit. For example, if you start a business and want to keep the IRS from challenging it as a hobby activity for which losses will be disallowed, you’re permitted to file Form 5213. Doing so keeps the IRS from auditing you for five years in most cases. At the end of this period, however, the IRS likely will look over your returns for these years to see whether you’ve met the presumption for a profit motive (profits in three out of five years for most businesses).

Note: While there is a perception that claiming a home office deduction is an audit red flag, there are no statistics to prove this to be true. Those eligible for the deduction should claim it without fear of audit. Worst case: Being eligible will enable you to win in the event you are audited.

How to Determine Whether You Qualify for the New Home Office Deduction

3. Don’t Misclassify Your Workers

One of the hottest audit issues today is worker classification, as the IRS is rather aggressively looking at companies and their payroll practices. The IRS frowns on businesses that treat workers as independent contractors when they exercise enough control over them to make the workers their employees. Companies may intentionally misclassify workers to avoid employment taxes, insurance and benefits required for employees, which increases costs by 30 percent or more; the IRS wants these payroll taxes for employees. Other companies may misclassify workers because they don’t know the rules.

Make sure you understand the tax law rules for worker classification. Labels don’t govern the tax results; the degree of company control is what matters. Also, having a worker sign an independent contractor agreement does not provide automatic protection for your classification of this person because the IRS isn’t a party to the agreement. Still, it doesn’t hurt to do so, and clearly shows the intended relationship between the company and the worker.

Learn how to properly classify your workers so if you're audited, your position will be respected and you won’t owe back employment taxes and penalties. The IRS has considerable information on this subject.

Want to sleep easier? If you’re on the fence about whether your independent contractor is properly classified as such, consider participating in the Voluntary Classification Settlement Program (VCSP) to reclassify this worker as an employee. If accepted into the program, you’re guaranteed protection from audits for past years. However, the program isn’t advisable for all businesses, so talk with your tax advisor about VCSP.

How to Survive a Department of Labor Audit

4. Don't Slack on Record-Keeping

It’s impossible to bulletproof yourself against audits, but you can walk away unscathed as long as you have the proof to support the tax positions you’ve taken.

  • Use software or cloud solutions, such as QuickBooks, to record your income and expenses. Doing so shows a business-like approach to your record-keeping.
  • Save receipts, canceled checks, business expense sheets and other documentary proof for your tax deductions. For example, keep a written record or use an app to track your business mileage if you deduct the cost of driving.

Learn what records and other documents you need to keep and for how long from IRS Publication 583.

Don't Miss These 5 Most Commonly Overlooked Small-Business Tax Deductions 

Consider seeking professional tax advice before you take any actions that could result in audit problems. Also think about having a tax professional prepare your returns. The cost of doing this can be much less than the cost of defending yourself in a tax audit.

For more financial tips, check out these finance articles.

Photo: iStockphoto

Barbara Weltman is an attorney and author of J.K. Lasser’s Small Business Taxes and The Complete Idiot’s Guide to Starting a Home-Based Business. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® at www.barbaraweltman.com