The percentage of small business audits has increased dramatically, anywhere from 36–94%.

At the 2012 IRS Convention in Las Vegas, this statement was made: “The Small Business is our largest audit group.”

Well, they are out there on the prowl. The IRS is targeting small businesses and any anomaly on your tax return can turn their crosshairs on you.

Since 2009, the percentage of small business audits has increased dramatically, anywhere from 36–94% of the various classifications of small businesses and owners. Audits for a small business are expensive, so if you can possibly avoid one, do so. Here are some things to think about:

1. Do you claim false business expenses? The IRS can spot these from a mile away. In the IRS Handbook, every profession and business has averages or standards for business expenses that the IRS follows when perusing your tax return. If you have used business money for your personal purpose, and then you claim that as a business expense, in the eyes of the IRS you have failed to report income. When considering your Schedule C expenses, the IRS will look for categories that are above the norms. This creates suspicion and the IRS is likely to check all of your accounts thoroughly. This is the number one reason for a small business audit.
2. Do you know about these red flags? There are certain categories on your tax return which, if used or used improperly, will send up an immediate red flag for the IRS. One category they really don’t like, even though it is legal, is the home office deduction. With more and more people working out of their homes, it seems only fair that they are allowed to deduct the expenses incurred by having a home office. The problem is in determining “fair expenses,” and that is where the IRS takes issue. Another deduction is for entertainment. Business people have to take out business clients, and this is a legitimate business expense. The problem is how much of the event you can deduct. This is another of those triggers, those red flags, that make the IRS look harder at your tax return than at others who are at or below the norms for the business. Talk with your tax consultant about how to report these and other categories which are in question.
3. How accurate are your business records? To avoid any problems, you need to keep accurate records of your business transactions. This can be less onerous if you have your tax consultant set up your business categories in a good business software. Stay up-to-date with entries, and always categorize expenses and income properly. Come tax time, your tax return will reflect your business correctly and precisely.
4. Do you answer every letter you get from the IRS? Even if you have answered a letter on the same subject in the past, send another copy of your response or write back to the IRS (or have your tax consultant do the task). The IRS can be brutal with non-response and can even go so far as to put levies on your bank accounts (read that: destruction of your credit score) or liens on your property. Don’t just file the letter: respond, even if it is with a copy of your previous letter to them.
5. Do you file your taxes on time? Do you file them at all? This is such an easy mistake to avoid. Even if you cannot pay your taxes, file the paperwork. If you don’t file, interest and penalties will accrue on what is owed. There is also a 3-year statute of limitations. The IRS has many challenges and audit procedures available to them, but none of this starts until your tax paperwork is filed. Also, after 3 years, you can’t collect any refunds which might be due. Not filing or late filing is going to niggle at you until you get it done. You will have this sword hanging over your head until you are again “straight with the government.” This is an easy fix: do it.

There is another problem which is just becoming significant in our society, and that is identity theft. I did not mention it in the above list for it still does not affect most people, but if it happens to you, it is a terrible thing. If you discover that you are a victim, you need a tax lawyer immediately. The IRS is very slow to correct identity theft, and you need an advocate who will help you through this morass.

Knowing that small business is the largest audit group means you need to do everything you can to make sure your records are audit-proof. In this age of huge government deficits, the IRS is going to be searching for more sources of money. The pressure is on. You will see the IRS stepping up compliance enforcement on small business, and you need to know what they are looking for. Be accurate, be on time, respond, and don’t step over the line on deductions.