If the IRS has ever audited your home-based business, it might feel as though fate has dealt you an unfair blow. “Why me?” you might ask. “I thought I did everything right,” you might explain. “But that was over two years ago, why now?” you might beg. Unfortunately, though being audited might feel like a random stroke of bad luck has befallen you, the truth is that the IRS looks for common patterns in the returns they select for an audit. If you file a return for your home-based business that contains one of several common triggers, your business is more likely to be audited, even if you’re filing a report that is completely accurate.
Home-based businesses can inadvertently trigger an audit for several reasons. Three items on your return that can lead to an audit include:
Reporting a Loss as a Sole Proprietor: While large enterprises and organizations often report significant losses and/or small profits as a matter of course, doing so as a sole proprietor can trigger an audit. Unlike large firms with clearly delineated business expenses, accounts payable departments, and many expenses throughout the year, sole proprietors may be more likely to have loose lines drawn between their personal and their business finances. Because of this, the IRS may interpret a loss on a sole proprietor’s return as the result of having improperly claimed personal expenses as business deductions.
Underreporting Cash Transactions, Even Unintentionally: If your home-based business processes large volumes of cash and you don’t have as stringent recordkeeping as you do for your credit card transactions, you could be increasing the risk that the IRS will audit your taxes. The reason for this is because the IRS has a secret formula for the cash your business is likely to have earned based on the 1099-K forms your credit card processor files with the IRS. If you get into a habit of rounding down your cash transactions to the nearest dollar, the IRS may deem your return worthy of an audit.
Miscalculating Figures: For electronic filers, much of the math on your return will be calculated automatically. But if you are completing the return for your home-based business by hand, mathematical errors in your favor can cause the IRS to audit your return. Both arithmetic errors and mistakes in your social security number can be problematic and raise a red flag at the IRS.
How to Prepare Your Home Business to Survive an Audit
The best way to avoid an audit is to file returns that avoid these three common triggers. But the best way to survive an audit is to make sure that you have detailed records to support each and every deduction you claim on your tax return. Since most audits occur 2-3 years after you file a return, you’ll need your detailed records to be clear, legible and easy to follow along long after you have sent your home business returns off to the IRS.
Here are three things you can do to prepare yourself for an audit:
Separate Business Expenses from Personal Expenses: One of the most common problems for sole proprietors is that their personal and business finances are intermingled. You may use your personal credit card to purchase gas for your car and gas to meet clients at meetings. The same card may have autopayments set up for both personal software subscriptions and business software transcriptions. One of the best ways to reduce the pain of an audit is to use a business credit card for all business related purchases. If the IRS forces you to defend each purchase as a verifiable business expense, you’ll already have your personal and business expenses separate.
Prepare Your Taxes as If You Will Be Audited: At the end of an exhausting week, making sure records of all of your expenses are clearly organized may be the last thing you want to do. But simply scanning your credit card statement and calculating your expenses is unlikely to help you in two years when the IRS decides to audit your returns. A better approach would be to use a cloud-based accounting software that allows you to automatically categorize your expenses on an ongoing basis.
Store a Digital Copy of All Records: Not only does holding onto a stack of paper receipts in your home office for several years clutter your workspace, but it can also cause an audit to be more painful than it needs to be. Recalling which receipts are for which expenses can be a time-consuming endeavor, especially as your memory of which receipts were for which purchases is likely to fade after a few days. Instead, choose a cloud-based accounting software with document capture so you can store and categorize a digital version of your home business’s financial records instead of relying on your memory and paper clutter. If you are audited, you will be able to share your electronic records to support your returns.
As the calendar year begins, now is an ideal time for you to evaluate whether tax returns for your home-based business are likely to trigger an audit – and whether your accounting and recordkeeping practices are enough to make an audit as pain free as possible. It’s also a great opportunity to consider updating some of your processes to store and categorize digital records of your business expenses instead of paper copies. The more work you do in January, the more pain free both next year’s tax season and future audits will be.
