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Protect Yourself from Audit Risk

How to Protect Yourself from Audit Risk

Protect Yourself from Audit RiskFor most small business owners, the 2023 tax season is behind them. But with increased funding for the IRS to step up audits of small businesses, getting a letter saying you’re under examination is something else to be concerned about. This is so even though the risk of being audited is statistically very low, at least for now. It’s impossible to obtain complete audit protection because despite every sound effort you make, the IRS can select a return at random for review. But there are steps you can take to greatly minimize your exposure to IRS scrutiny. These actions can help you going forward.

Steps to help protect yourself from audit risk

Pick up all income from information returns

The IRS reported in its Data Book for the 2022 fiscal year ending September 30, 2022, that it proceeded almost 5.5 billion information returns—third-party reports on items of income, expenses, and other items. IRS computers use this information to check that income is reported on the returns of taxpayers who received them. When things don’t match, the IRS sends a letter to resolve the discrepancy, and this could become an audit trigger. For small business owners, pay special attention to:

  • Form 1099-K reporting payments made to you through third party payment processors, such as your bank or PayPal. While you aren’t required to reconcile the numbers on your return (the 1099-K doesn’t take returns and allowances into account), be sure you can account for the reported payments.
  • Form 1099-MISC, reporting payments for your business, such as rents, prizes and awards, fishing boat proceeds, crop insurance proceeds, gross process paid to an attorney, and certain deferred compensation.
  • Form 1099-NEC, reporting nonemployee compensation (i.e., payments to independent contractors.

Be cautious about filing certain forms

When your tax return is completed using software—by you or your tax professional—information you input automatically populates the return. However, discuss carefully with a tax adviser whether to take positions that suggest or mandate certain forms and schedules that virtually guarantee a closer look by the IRS. These include:

  • Form 5213, Election to Postpone Determination as to Whether the Presumption Applies That an Activity Is Engaged in for Profit. This form is used if you have an activity and want to deduct losses but are concerned that you can’t prove this is a business rather than a hobby. The form postpones any inquiry until the end of 5 years (7 years for certain horse activities), but probably assures an IRS look at your activity at that time. If you have a realistic profit motive (there are 9 factors that the IRS and courts look at), you can take losses and don’t need to file the form. But be prepared to back up your belief if your return is questioned.
  • Form 8275, Disclosure Statement. This form is used to tell the IRS about items or positions not otherwise adequately disclosed on the return in order to avoid certain penalties. Do you really want to take this position?
  • Form 8275-R, Regulation Disclosure Statement. This form is used to tell the IRS that a position contrary to regulations is being taken on a tax return in order to avoid certain penalties. Again, do you really want to take this position?

Use a reputable tax return preparer

It’s vital to get good tax advice so you can legally minimize your tax bill while avoiding unwarranted attention to your tax return. The IRS cautions taxpayers to avoid unscrupulous tax return preparers. If the IRS tracks down such a preparer, it likely looks over the preparer’s client list and can then audit those clients.

The IRS warned small businesses against ERC mills—preparers that erroneously help small businesses claim the employee retention credit (ERC) though not entitled to it. There have been reports of massive fraud, and the government may be gearing up for audit in this area.

Final thoughts

So, there’s no bulletproof way to protect yourself from audits, but there are things you can do to sleep better. In addition to the actions discussed earlier:

  • Ignore the old myths. In the past, one of the common audit red flags was claiming a home office deduction. This is no longer true, given the fact that half of all small businesses start from home and 60% of those without employees are home based.
  • Keep great books and records. If you are audited, you’ll have the documentation needed to back up your claims and avoid owing extra taxes, interest, and penalties.

For more information about audit risk, see an earlier blog, Audit Vulnerability for Small Businesses here.