How to avoid a tax audit: 7 tips for small business owners

The nightmare goes something like this: you’re busy at work when a stone-faced man with a dark suit and a big briefcase appears in the doorway. He is an IRS agent and he has come to audit you. He wants to see all your receipts for the last five years. He wants to have a look at your home office. He wants all of this now.

You start to tremble. You don’t exactly have receipts for everything. Your unemployed son has been living in the “home office” for the past few months. You might have forgotten to report some of your income. And you can tell by looking at this guy that he’d love nothing better than to arrest you for tax evasion.

Fortunately, the nightmare is more fantasy than reality. Only a tiny fraction of small businesses get audited. And when they do, they usually receive a letter—not a visit—from the IRS asking for more documentation to clear up a discrepancy.

Still, no small business owner wants an audit. Here are some small business tips on how to avoid a tax audit and deal with one if it does happen.

1. Check your numbers

When someone issues you a tax form that reports income, such as a 1099, they also report that information to the IRS. The IRS will expect the numbers on your tax return to match what they’ve received from third parties. If there’s a discrepancy, the IRS will issue you a notice or could audit your return.

Your tax return can also attract unwanted attention if the numbers simply don’t add up. Mistakes are easy to make, so double-check any information you put on your return, and also check your math. Consider having an accountant prepare your return or use tax preparation software that will do the math for you.

2. Don’t report a loss every year

If you report a net loss in more than two out of five years, you’re a likely candidate for a tax audit. And chances are, the IRS may determine that your business is a hobby and disallow all your business expense deductions.

3. Keep good records and report income and expenses accurately

You’ll minimize your risk of an audit if you keep all your business income and expenses in a business bank account and retain your business expense receipts. Not only will this make it easier to prepare your tax return, you’ll have what you need to support your return if you ever were audited.

On the other hand, you increase your audit risk when you try to hide income or overstate your expenses. And while it’s fine to round numbers to the nearest dollar, rounding to tens or hundreds can give the IRS the impression that you’re just making up numbers.

4. Don’t pay overly high salaries to employees who are shareholders

If you have a C corporation, paying your executives a high salary can be a way to minimize corporate profits and therefore pay lower taxes. For this reason, unusually high salaries may open your tax return to scrutiny. Know what a reasonable salary range is for your industry, and don’t exceed it.

5. Be careful of independent contractors

Businesses are more likely to get audited if they have a high ratio of independent contractors to employees, because using independent contractors can be a way to avoid paying payroll taxes. The IRS has clear guidelines on who can be an independent contractor and who must be classified as an employee. Make sure you know and follow the rules, and when in doubt, get small business advice from a tax lawyer or accountant.

6. Only claim a home office if you can legitimately take the deduction

Home offices have a bad reputation as red flags for tax audits, but these days you can safely take a home office deduction if your space legitimately qualifies. For most people, this means that the home office must be a separate room that’s used exclusively for business—a desk in the corner of the living room won’t work. However, a home office can still create an audit risk if you have large expenses for maintenance or utilities, or you claim a home office and also rent office space elsewhere.

7. Pay your estimated small business taxes

If you expect to owe at least $500 in taxes for your business entity at the end of the year, you should be making quarterly estimated tax payments. Failing to make these payments can result in penalties and can put you at greater risk for an audit.

If you keep good records and are honest on your tax return, you don’t need to fear a tax audit. But if you’re unsure of the income you should report and the deductions you’re allowed to take, it’s always a good idea to seek tax advice from an accountant.