5 Accounting Practices That Could Lead to an Audit

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Are you “asking” for an audit by the IRS? For even the most organized, efficient, honest small businesses, the threat of an audit can be enough to send owners and accountants into a cold sweat.

The good news is that the IRS audits just slightly more than 1% of all individual tax returns each year. They don’t have sufficient personnel and resources to closely review each and every tax return filed, so the odds are low that your return will be picked for review.

That said, your chances of a call from the IRS do increase with key indicators (including your income bracket, specific deduction types or losses claimed, your earning methods or other issues many business owners are unaware of). Computing and mathematical accounting errors may draw IRS inquiry, but this does not necessarily mean an audit is looming.

Here’s a few audit flags you may be able to avoid.

  1. Home Office Deduction:
    Things have improved, yet even as the IRS looks more kindly on the HO deduction than in past years, it is still a red flag: most notably when your deduction for working in your pajamas is a large one. If you claim your buildout or other major home maintenance and/or utilities costs, that portion of your return will be closely scrutinized by the IRS. If you claim both a home office and a brick-and-mortar professional office, your scrutiny and risk increases significantly.
  2. Subcontractors:
    Most small businesses learn this one pretty quickly. If your company contracts with more subcontractors than employees, it will increase its risk of an audit. This is especially true for small businesses, which tend to issue a large number of 1099 forms at the end of the year in contrast to their overall revenue. What’s the big deal? It is simple: the IRS wants to know that you aren’t skimping on payroll taxes by over-contracting with long-term dedicated workers.
  3. Miscellaneosity:
    Watch out for over-use of the Miscellaneous Expense option on Schedule A. Itemize those business expenses under the correct categories on Schedule C. This mistake is common for small businesses in their first few years of operation.
  4. Accrual vs Cash:
    Pretty much all businesses can use the accrual accounting method, while the cash accounting method is more specific to unique business types. The accrual method records income items when they are earned and records deductions when expenses are incurred. The cash method records revenue when cash is received, and expenses when they are paid in cash.
  5. Profitability:
    It is little known to most business owners (unless they get that knock on the door) that according to Federal Tax Law, all US businesses must show a profit 3 out of every 5 years. If you stagnate or lose money 4 years in a row, the IRS will essentially classify your business as a hobby and the likelihood your file will be reviewed goes up.

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