What Triggers a Business Audit?

Any business owner can easily relate the Audits conducted by the Internal Revenue System (IRS) as a nightmare for them and they may not leave any such chance of avoiding it. Another reason maybe, the IRS keeps the exact criteria it uses for auditing select business tax returns a secret. It pays close attention to how businesses file their taxes each year. Its scrutiny of companies' tax returns ensures that businesses pay what they rightfully owe to the federal government.

The chances of the IRS auditing your taxes are somewhat low. While there’s no guarantee that you can prevent an audit, there are tactics to make the prospect less likely and things you should and shouldn't do if the "tax man" does come knocking on your door. 

How does it works?

The IRS has a computer system that's specifically designed to detect anomalies in tax returns. It’s called Discriminant Information Function or DIF, and it scans every tax return received by the IRS. It looks for things like duplicate information as the computer compares each return to those of other taxpayers who earned approximately the same income. Most people who earn $40,000 a year don’t give $30,000 of that money to charity, so DIF is pretty much guaranteed to throw up a flag if you claim that you did. 

If your tax return intentionally differs from any of your tax forms, including a clear explanation with your tax return may be enough to satisfy the reviewer without a formal audit being initiated. However, The IRS isn't going to waste time its time on an audit unless agents are pretty sure that the taxpayer owes additional taxes and there’s a good chance that the IRS can collect that money. This puts a focus on high income earners such as those who have earned $200,000 or more in a year.

Reasons for Tax Audits

The audit process includes some random selection, but there are certain triggers that are known to make an audit more likely, these includes:

• High Income or Assets: The IRS Data Book shows that businesses with balance sheets reporting assets less than $250,000 were audited 0.9 percent of the time while those with assets between $5 million and $10 million were audited at roughly double that rate. Corporations with balance sheets of greater than $20 billion were audited 84 percent of the time.

• Excessive Deductions: As a business owner, you are entitled to deduct certain business expenses on your taxes. However, to avoid an audit these deductions must be reasonable and also must reflect the amount of money and business that your company does on a regular basis. Large deductions that reduce the amount of your taxable income may raise a flag if they are out of proportion with your income. 

• Tax-Exempt Status: The IRS may also conduct an audit when it notices unusual patterns on individual tax returns related to deductions for donations to the organization.

• Repeated Losses: The IRS takes notice when businesses repeatedly show a loss. They know some people claim hobby expenses as business losses, and under the tax code, that’s illegal. If you run a legitimate business that continuously reports a loss, the IRS may assume you are taking deductions you’re not entitled to in order to avoid paying taxes.

• Assets or Cash in another country: The IRS is particularly interested in taxpayers who have assets and cash stashed in other countries. It can access your account information from a foreign bank, and it will do so if it feels that you may owe taxes on the money you've placed there. 

• Missing Income: If you forget to report income for which you received a 1099, such as $650 that you received from a client for a small project, you may draw the attention of the IRS. The IRS compares the amount you report on your return to any 1099s or W-2s it receives.

Usually, many small businesses face an increased risk of being audited by the IRS because they are in control of what income and expenses they report. But if they keep accurate records to back their tax return, an audit should be resolved quickly in their favour.