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After you receive an audit notice from the IRS there is nothing you can do to avoid it. However, there are some things you can do to reduce the chances of being chosen in the first place.
The dreaded IRS audit. After you receive an audit notice from the IRS there is nothing you can do to avoid it. However, there are some things you can do to reduce the chances of being chosen in the first place.
Realistically, the IRS has the resources to examine only a small fraction of all tax returns filed. So, it selects tax returns which have significant audit potential, specifically, those which are most likely to result in a large tax deficiency.
Situations that Attract IRS Audit Attention
High Salary Expenses in Closely-Held Corporations
The IRS looks for unreasonable compensation for officers of family-owned companies, and may attempt to recharacterize such compensation as a nondeductible dividend distribution. To avoid IRS scrutiny, make sure the salary you pay yourself is in line with that of others in your industry. Owners of small corporations should also keep detailed records of hours worked, unique contributions provided to the business, and any other factors which may affect how much the owner is paid.
Large Business Deductions
The IRS looks at your business deductions in comparison to the amount of income you earn. If deductions are high relative to your income, it will likely raise a flag with the IRS. To defend yourself, thoroughly document every business deduction you claim on your tax return.
Meals & Entertainment Expenses
The IRS believes than many taxpayers claim business tax deductions for these costs which should actually be personal, non-deductible expenses. If you deduct amounts paid for business meals or entertainment, be sure to retain written records of the business purpose of the expense, the people who were in attendance, and the business matters discussed.
Cash-Based Business
If you own or work in a business which commonly transacts in cash, you are much more likely to be audited. Report all the income you earn, and make sure that the amount of cash income or tips you report on your tax return is reasonable in relation to the non-cash income you report.
Large Itemized Deductions
You may attract IRS scrutiny if your itemized deductions exceed a target range set by the IRS. Again, the ranges are relative: you will only attract attention if your deductions are large in comparison to your total income.
While the above factors increase your chances of IRS attention, they do not guarantee that you'll be subject to an audit. You should not avoid taking legitimate personal and business deductions simply because they increase IRS scrutiny of your tax return. Remember that, in general, your chances of being audited are fairly small. If you think the IRS may question a large tax deduction or tax credit, attach an explanation to your tax return when you file it.
The IRS has selected several industries and occupations for special examination, and has created documents called Audit Technique Guides (ATGs) to help its audit personnel examine these particular market segments. Many of the ATGs are published at the IRS' Web site, and they can be very useful reading for the small business owner who wants to avoid, or to do well in, an IRS audit.
Sometimes, despite your best efforts, you will find yourself subject to an IRS audit anyway. Many audits end with no additional tax being due. For information regarding the audit process, see How to Survive an IRS Audit.
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