What does the IRS look for in an audit of my small business?

Running a small business is challenging on a day-to-day basis, with each day bringing the possibility that you could be faced with cash flow issues, employee-related matters, problems with business partners, and much more. But there is always one other significant possibility that can keep you awake at night: the possibility that the Internal Revenue Service may come calling to audit your business. 

Although your risk of being audited may be low, as a prudent businessperson you need to be prepared for the possibility. This post will briefly introduce some of the most common “red flags” that IRS auditors are trained to look for as being potentially suspicious.

Large amounts of personal entertainment expenses shown as business expenses: Especially if you run a small business, the IRS will look for evidence that you are crossing the line between legitimate entertainment expenses and personal entertainment, such as claiming vacation travel as a business expense. If you cannot satisfactorily support the business nature of such amounts with documentation, then this can become a problem for you. 

Automobile expenses: It is permissible to use your car for both personal and business use, but the more you claim such usage to be business-related expenses, the more likely it becomes that those expenses will be scrutinized for supporting documentation, such as mileage logs.

Independent contractors: The contractor or “freelancer” is becoming a staple of how many businesses use the services of others, but you need to be careful not to be seen as trying to avoid payroll taxes by claiming employees as contractors. The more you use contractors, and the longer you use them, the more this suspicion can grow.

Income vs. lifestyle: If your possessions such as your home and your car juxtaposed with your business income suggest to an auditor that you are hiding income from your business taxes, auditors are trained to notice this.

This post cannot cover all of the factors that tax auditors will consider when performing an audit of your business, nor should you take what you read here as legal advice in the event of an audit. The best way to cope with an audit is to be prepared for the possibility of one, and in this regard working with an accountant and a commercial tax law firm can represent sound business investments.

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