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There are rising expectations that federal tax enforcement will be increasing in coming years and that the small-business sector will make up a significant portion of that effort. So, business owners need to be prepared if their enterprise is one that the IRS wants to take look at.
Why audit rates may increase
Audit rates for all taxpayers — individuals, corporations, and partnerships — declined substantially from 2010 through 2017, in many cases by 50 percent or more. This trend may reverse as the Inflation Reduction Act of 2022 increases IRS funding by $80 billion over the next decade after two decades of funding declines relative to the size of the U.S. population.
Of that $80 billion allocated to fund the IRS and increase taxpayer compliance, the bill authorized $45.6 billion specifically for enforcement.
IRS Commissioner Charles P. Rettig stated that the agency will direct increased audit efforts toward large corporate and global high-net-worth taxpayers, pass-through entities, and multinational taxpayers ― not households earning less than $400,000 annually or small businesses, according to his August 2022 letter to the United States Senate.
But many small businesses, including limited liability companies that elect to be taxed as S-corporations and sole proprietorships, are pass-through entities, meaning that the business’s income passes directly to the owner. They could seemingly be in the targeted category, according to Rettig’s statement. Also, it’s not clear where the IRS will draw the distinction between “small” and other businesses.
And the small-business sector is where collections fall short. Indeed, underreported tax liability from sole proprietorships, partnerships, limited liability partnerships, and limited liability companies makes up a huge part of the tax gap, which is the difference between what the IRS estimates taxpayers owe and what taxpayers report owing. It made up more than a third of the total $441 billion annual average tax gap during 2011, 2012, and 2013, according to the most recent federal tax compliance research published by the IRS.
What to do if your small business gets an audit notice
The IRS conducts audits in two ways: by mail (correspondence audit) or at your place of business (field audit). Correspondence audits were more common for businesses with gross annual receipts under $100,000, and field audits were more common for businesses with gross annual receipts of $100,000 or more for the 2018 tax year.
If you get a notice of either type of audit, a good first step is to contact a financial or legal professional who can represent you before the IRS, such as an enrolled agent, certified public accountant, or tax attorney. Check out the IRS’s guidance on choosing a tax professional if you’re unsure where to start.
“Do not under any circumstances represent yourself or open all your books and receipts unless your accountant or attorney says these are really required,” said Paula C. Brancato, a MassMutual financial professional with Barnum Financial Group in Long Island City, New York.
Your representative can help you understand what information the IRS expects you to provide and communicate with the IRS employee assigned to your audit. You’ll have to pay for the services of your representative, of course, but it may be worth the cost if it means less time away from your business, less stress, and the possibility of a better audit outcome. Plus, you may be able to claim a business tax deduction for their services.
A MassMutual financial professional can help you with more holistic financial planning for your small business, including strategies to legally minimize your taxes — such as setting up a self-employed retirement plan.
Common small-business types and deductions flagged for IRS audits
Small-business owners have an array of business deductions at their disposal and may intentionally or accidentally claim things they shouldn’t (e.g., personal expenses) to reduce their taxable business income. In fact, abuses and errors in certain types of businesses and categories of business deductions are so common that the IRS has dedicated audit procedures for them.
The IRS may be more likely to audit your small business under certain circumstances, including the following:
- Cash-intensive business. You own a restaurant, convenience store, construction company, or other business that regularly receives or makes cash payments.
- Child care business. The IRS says child care providers often underreport income, overstate expenses, transact in cash, and keep poor records. The IRS also defines taxable child care more broadly than the average person might expect.
- Vehicle deductions. Some people overstate their deduction by claiming both actual costs and mileage expenses when you can only claim one or the other. It’s also common to not keep adequate records for the business use of a personal vehicle.
- Meal, travel, and entertainment deductions. People may take these tempting deductions for expenses with no business purpose. Poor recordkeeping is also common.
- Home office deduction. Small-business owners often mistakenly deduct expenses for a portion of their home they don’t use regularly and exclusively for business. Or, they take the deduction without keeping records to substantiate it.
- Low wage with S-corp election. It’s a myth that you can set up your small business as an LLC, then elect to be taxed as an S-corp and underpay yourself to reduce your tax bill.
- Earned income tax credit. Some individuals report nonexistent self-employment income as a way to fraudulently claim the earned income tax credit.
- Paycheck Protection Loan recipient. You’ve probably seen the headlines about the rampant fraud associated with forgivable pandemic loans to small businesses. The IRS will be looking to see whether small businesses used these loans as intended. If not, it can tax the proceeds as income.
You might also get audited because of a typo, missing information, or a math error. Your association with someone else the IRS has found problematic in an audit, like your tax preparer or someone you do business with, could also trigger an audit. In addition, IRS software could randomly select your return for an audit.
The likelihood of your small business being audited
For the 2011–2019 returns it had examined as of May 2022, the IRS has audited business tax returns at the following rates:
- Partnership: 0.1 percent
- S-corporation: 0.1 percent
- Corporation other than S-corp: 2.9 percent
The most recent fiscal year for which the IRS breaks out audit rates of individual tax returns with Schedule Cs is 2018. Here’s how audit rates played out by gross receipts:
- Under $100,000: 0.9 percent
- $100,000 to $200,000: 2.4 percent
- $200,000 or more: 1.9 percent
Reviewing IRS Form 11652 can give you an idea of what the IRS might ask for in a correspondence audit of your business’s Schedule C. The IRS Small Business Recordkeeping Center provides guidance on small-business recordkeeping requirements.
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