IRS Audit: How It Works and How to Avoid One

5 min read

IRS Audit: How It Works and How to Avoid One

The term "audit" is derived from the Latin word Audire, which means "to hear." It is, in fact, a "hearing" of your business accounts by the tax authorities. There are no men in black suits with earpieces knocking on your door, nor are there any filing cabinets being emptied.

Audits become more inconvenient than frightening once you understand how they work. We'll go over that first, then move on to ways to avoid being audited—as well as how to make the process go more smoothly if it happens.

What exactly is an audit?

When the IRS audits your company, they thoroughly examine your financial records. This includes going over your financial statements and making sure they match up with your bookkeeping. They typically want to ensure that you are not underreporting your income or overreporting your deductible expenses. You are reporting a lower tax liability than you actually have in either case.

What happens during an audit?

An audit can take one of the following three forms:

1) When the IRS determines that you owe no money, they leave you alone.

2) The IRS discovers that you owe money to them. You sign a legal document attesting to your debt. Then, you submit payment.

3) You challenge the IRS's determination that you owe them more taxes. You will need the expertise and knowledge of a tax attorney, an enrolled agent, or a CPA in this situation. Depending on your reasoning, the IRS may lower your debt, ask you to pay the whole amount, or drop the accusations altogether.

What triggers an audit?

It is nearly impossible to predict an audit. However, they are triggered for one of three reasons:

1) The system used by the IRS selects people at random.

2) Computer screening—returns that deviate from IRS "norms" are flagged.

3) Examining by association—If your tax return is linked to the return of another taxpayer who is being audited, you may be audited simply because of that connection.

Small business markers that could lead to an audit: 

- Failure to notify the IRS of previously reported income (on W2s or 1099s). You could face tax evasion charges.

- Taking unusually large deductions, such as deducting your personal car use in full. You could face tax evasion charges.

- Misclassification of employees

- Non-filing of information returns (W2s, 1099s, and so on).

- Failure to report taxable crypto activity may result in penalties, interest, and even criminal charges. It may be considered tax evasion or fraud.

Auditing Scenario:

In the movies, a swarm of IRS agents bursts through your door and raids your workplace. Your business partner travels to the Cayman Islands by private jet. Your accountant retreats to the restroom. Your secretary has left the company.

In reality, an audit does not look like that. (However, in exceptional circumstances, the IRS may conduct a field audit.)

There are typically three types of audits:

1) Correspondence audit. The IRS will contact you via email or postal mail to request additional information. This is usually due to an income omission or another serious error. You must either pay the amount specified in the correspondence, file a legal challenge, and/or provide the necessary documentation, such as deduction receipts or missing W2 forms.

2) Office audit. The IRS may request an in-person interview with you. You will have to go to the IRS office. It's a good idea to bring along a CPA or a lawyer. If you contest it, you may end up paying more in taxes or penalties, or you may not have to pay anything at all.

3) Line-by-line audit. This was chosen at random. The IRS scrutinizes every line of your tax return to determine the "norms" that will trigger future audits.

Don't worry, though. As long as you comply (or legally contest), provide sufficient evidence where necessary, pay the fines, and demonstrate that you did not act with criminal intent, you will be in the clear.

How to Avoid an Audit?

There is no way to know for sure that you won't be audited. However, if you do the following, you can significantly reduce your chances of being subjected to one.

1. Account For Every Source of Income

The IRS compares the income and deductions you report on your tax return with the information reported by others, such as your employer, bank, or business, using the information on Forms W2, 1098, and 1099. Any discrepancies in reported income amounts that result in tax underpayment are a major red flag for the IRS. It will almost certainly lead to additional investigation.

So, if you have a side hustle, such as consulting or freelance work, report it even if you think you can get away with it.

2. Double Check Your Return

One of the simplest ways to ensure a visit from the tax man is to make a careless mistake on your tax return.

If there are any omissions, miscalculations, or errors on your tax return, the IRS is required to conduct an additional investigation. Hire a bookkeeper to ensure that your books are accurate and ready for taxation.

Vincere Tax not only does your books, but can also file your taxes for you. If you want to speak with a tax professional, click here.

3. Keep Your Accounting Method Consistent

As a business owner, you can choose between cash basis and accrual accounting. If you alternate between the two methods, the IRS may suspect you're attempting to confuse them. You will be audited at that time. Make sure that whatever accounting method you choose for your company is consistent.

4. Keep It Clear — Employee or Independent Contractor?

When hiring help, you must determine whether the workers are employees or independent contractors. This distinction determines which taxes must be paid, when they must be paid, and who is liable for them.

Employees are usually required to pay income taxes as well as unemployment, social security, and Medicare taxes. You are not required to withhold or pay taxes on the income of an independent contractor.

What is the Tax Auditing Statute of Limitations?

The IRS has three years from the date you file your tax return to audit you for that tax year. There are, however, a few exceptions:

- Significantly underreporting your income

If you fail to report more than 25% of your gross income, the IRS can audit your federal tax return for up to six years. This also applies if you pay the same amount as if you had underreported 25% of your gross income through other means.

- Excluding foreign income

The IRS statute of limitations is extended to six years if you fail to report $5,000 or more in foreign income, such as cash held in an offshore account.

- Failure to complete IRS Form 5471

The statute of limitations runs indefinitely if you own stock in a foreign corporation and fail to report it on Form 5471. That means the IRS could audit you for any tax return you've ever filed.

- Never filing, or filing a fraudulent return

The statute of limitations is indefinite if you have never filed taxes or if the IRS determines that one of your returns is fraudulent. This fraud penalty may apply even if you made an honest mistake, such as forgetting to sign your tax return or inadvertently changing the "penalties of perjury" text at the bottom of the form.

How to Make an Audit Easier

Nobody likes to consider the worst-case scenario. However, if you take the right steps now, you can make a future tax audit less painful.

Here are two things you can do to make an audit less intimidating:

1. Keep Meticulous Records

If you keep your small business records in order, you will be able to back up anything the IRS requests more quickly and easily. The IRS frequently investigates the difference between a hobby and a business. According to the IRS, if you have a non-business activity, your "allowable deductions cannot exceed the activity's gross receipts." This is known as the "hobby-loss rule" in some circles. Keeping accurate books and using financial records to back up your claimed profit margin will help demonstrate that you are running a legitimate business rather than, say, claiming tax deductions for your personal macramé workshop.

2. Separate Your Personal and Business Expenses

According to the IRS, business owners must keep their personal and business finances separate. Unless your company is a sole proprietorship, you must keep your business and personal expenses separate by law.

When you combine expenses, you pierce the corporate veil. This means that if your company owes money, creditors, including the IRS, can seize your personal assets. If you are currently mixing business and personal expenses in the same account, open a small business bank account as soon as possible and separate your expenses.

Keeping all of your business expenses in a separate business bank account will make dealing with a tax audit much easier. This is because it creates a legal barrier between your personal and business assets.

IRS Penalties and Fines

So you made an error when you filed your taxes. Perhaps it was discovered during an audit, or perhaps you forgot about it during tax season and arrived late. Don't be concerned! Unless you had criminal intent, you're unlikely to be imprisoned or have your small business taken away.

The following are the IRS tax penalties for the most common non-criminal offenses.

Penalties for not meeting a deadline:

Late filing of taxes

- First and foremost, you can always ask for a tax extension. If you file your taxes more than 60 days after the due date or extension date, the minimum penalty is $205, or 100% of the amount owed if you owe less. This is true only if you file within 60 days of the 60-day deadline. If you do not file for the subsequent months, you will be fined 5% of the unpaid tax per month. Even if you know you won't be able to pay your entire bill, you should still file your taxes and pay what you can. Interest charged by the IRS can add up quickly.

Late payment of taxes

- You must pay an additional 0.5 percent of unpaid tax each month until you have paid off your entire tax bill, up to a maximum of 25% of your total tax bill. Keep in mind that this penalty applies even if you sent in a check on time but it bounced.

Penalty for both late filing and late payment

- Fortunately, these two penalties are not cumulative. If you are late on both, you will only be charged 5% interest per month.

Paying your taxes late after receiving a Notice of Assessment

- If the IRS discovers that you owe more taxes than you previously believed, they will send you an Issuance of Notice requesting the additional payment. After that, you have 21 calendar days to pay the extra amount, or 0.5 percent interest per month will begin to accrue.

Late submission of a form

- Failure to return a W2 (for employees) or a 1099 (for contractors) results in a $50 fine.

- Failure to return a 1065 form (for partnerships) or a 1120S form (for S-Corps) on time will result in a fine of up to $195 per month per partner.

Penalties for making an error:

Incorrectly calculating your owed taxes

If you significantly underestimate how much tax you owe, or the IRS determines you were negligent in an aspect of your taxes (i.e., it wasn't a minor mistake), the penalty is a 20-40% increase in taxes owed.

Employee taxes are being calculated incorrectly.

There is a 100% penalty on all unpaid federal employee taxes. In other words, if you don't pay employee taxes the first time, you'll have to pay them twice. Failure to report employee wages through your payroll provider and failure to report employee tip income are the two most common scenarios.

When is something considered a crime?

If the IRS determines that your error was more than carelessness and that you lied, filed a false return, or purposefully violated tax laws, you have broken the law and may lose your property or face jail time. The IRS is not playing games.

Source: Vincere Wealth

I hope this information was helpful! If you have any questions, feel free to reach out to me here. I’d be happy to chat with you. 

Connect with Josh

About the Author

As Managing Partner of Vincere Wealth, Josh assists clients in navigating financial challenges and making sound financial decisions. Having someone guide you in making sensible financial decisions today can have a substantial impact on your future financial wellbeing. Josh takes great pride in guiding customers through the complexities of taxes, real estate, businesses, employer stock and international financial planning.

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This post is just for informational purposes and is not meant to be legal, business, or tax advice. Regarding the matters discussed in this post, each individual should consult his or her own financial advisor, attorney, business advisor, or tax advisor. Vincere Wealth Management accepts no responsibility for actions taken in reliance on the information contained in this article.

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