IRS Tax Audits: What Every Business Owner Should Know

When thinking about risks to your company, you might picture a natural disaster or an unstoppable competitor. An IRS audit may not immediately come to mind. But getting that fateful letter in the mail can still hurt morale, impede productivity and delay the accomplishment of strategic objectives. Here’s what every business owner should know about the process.

Return-related risks

The IRS maintains that many business audits occur randomly. That said, a variety of tax-return-related items are likely to raise red flags with the IRS and may lead to an audit. For instance, if the agency notices significant inconsistencies between previous years’ filings and your most current filing, it could decide to pursue the matter.

Maybe you just had a really good year — or a really bad one. But if your company’s income seems substantially higher or lower than in previous years, you’ve got to be able to clearly show why. On a similar note, if your gross profit margin or expenses are markedly different from those of other businesses in your industry, it may trigger additional IRS scrutiny that, in turn, could lead to an audit.

Miscalculated or unusually high deductions also are a common audit trigger. Remember, to be deductible, business expenses must be “ordinary” and “necessary.” You can’t deduct personal expenses, such as clothing or the nonbusiness use of vehicles or computers. Other expenses, including certain meal and entertainment expenses, may be at least partially deductible. But you’ve got to follow the rules.

Bigger picture issues

Your company’s tax return is the most obvious place to look for foibles or inconsistencies that could lead to an audit. But there are other, “big picture” moves that ultimately lead the IRS to audit many businesses. Here are a couple of specific examples to watch out for:

1. “Unreasonable” compensation. The agency may scrutinize any business owner who draws a salary that’s inordinately higher or lower than those in similar companies in his or her location. But corporations are in particular danger here.

In the case of C corporations, the IRS may consider a high salary as dividend income and deny deductions for any associated compensation expenses. For S corporations, the IRS may reclassify excessive distributions as wages, making the shareholders liable for additional payroll taxes on the amount.

Thus, if you’re incorporated, make sure you pay any shareholders who work for the company within the standards of “reasonable compensation.” What’s considered reasonable is subjective, but the basic rule is that shareholders should pay themselves what they would pay others to do their jobs.

2. Employee misclassification. With the increasingly common use of independent contractors — also known as the “1099 economy” — businesses remain at high risk of running into an audit because of improper employee classification. The temptation is to classify workers as independent contractors to avoid payroll taxes (and benefits). But if the IRS reclassifies an independent contractor as a bona fide employee, you could end up paying back taxes, interest and other penalties.

The distinction between employee and independent contractor is determined by a variety of factors, including the amount of control a company has over how the person works and by the support given to that individual. To steer clear of IRS trouble, explain your desired results to the independent contractor and provide a deadline. But leave how, and, to the extent possible given the work in question, when and where the work is done to the contractor.

Response measures

If you’re selected for an audit, whether randomly or because of one of the issues mentioned (or another matter entirely), you’ll be notified by letter. Generally, the IRS won’t make initial contact by phone. But if there’s no response to the letter, the agency may follow up with a call.

The good news is that many audits simply request that you mail in documentation to support certain deductions you’ve taken. Others may ask you to take receipts and other documents to a local IRS office. Only the most severe version, the field audit, requires meeting with one or more IRS auditors at your office.

More good news: In no instance will the agency demand an immediate response. You’ll be informed of the discrepancies in question and given time to prepare. To do so, you’ll need to collect and organize all relevant income and expense records. If any records are missing, you’ll have to reconstruct the information as accurately as possible based on other documentation.

The best news of all is that no business owner has to go through an audit alone. We can help you:

• Understand what the IRS is disputing (it’s not always crystal clear),
• Gather the specific documents and information needed, and
• Respond to the auditor’s inquiries in the most expedient and effective manner.

The weaker or more complex your case, the more value your accountant can provide. In addition, IRS agents are often more comfortable dealing with professionals who understand tax law.

The right approach

Don’t let an IRS audit ruin your year — be it this year, next year or whenever that letter shows up in the mail. By taking a meticulous, proactive approach to how you track, document and file your company’s tax-related information, you’ll make an audit much less painful and even decrease the chances that one happens in the first place.

Questions? Contact your Smith and Howard professional at 404-874-6244 or fill out the form below.