In late 2015, the IRS announced that audits of individuals had dropped to an 11-year low. Presently, the odds of an individual being audited by the IRS are slim at less than one percent. While the majority of taxpayers are relieved to hear this, the reality is that owning a business inherently increases your chances of being audited. Not to mention, there are various other audits, including at the state level, which are all the more common. In my own professional experience, I have seen more sales tax and department of labor audits by the state, than IRS individual tax audits.
A quick internet search will return many articles listing deductions and credits which could potentially raise your audit risk. Below are a few items, specific to business owners, which you likely won’t see listed often.
Does your tax return justify your means of living?
This seems obvious, but you’d be surprised how often I’ve seen it. If you live in a house where you are paying $20,000 of property tax annually and $20,000 of mortgage interest (not including the principal you’re paying also), the IRS will have a hard time believing you’ve reported all of your income if you’re only showing $80,000 for the year. In many instances, there are logical explanations, such as investments, which can support this lifestyle. In most cases, it’s simply underreporting of income, such as cash. When finalizing your individual income tax return, take a step back and ask yourself if your income really justifies your means of living.
Do your sales tax returns match your annual taxable sales?
This is another common mistake which happens all too often. You have a business where you collect and remit sales tax to the state. You have an obligation to file sales tax returns which show your total taxable and non-taxable sales for each period. At year-end, your sales tax returns total $500,000 of gross sales, whereas your business tax return shows $750,000. This is a flag that will ultimately trigger a sales tax audit, and then potentially an income tax audit, as states are getting much better with sharing information to the fed. Be sure to coordinate with your accountant to prevent this issue from occurring.
Do you have a vengeful ex-spouse or employee?
This is one of the biggest reasons for an audit that no one talks about. If you have a vengeful ex-spouse or disgruntled employee that knows of some sort of tax fraud or underreporting of income that you are committing, you should know that the IRS actually offers whistle-blower awards which are percentages based on the ultimate collections of tax, penalties and interest.