In 2017, the Internal Revenue Services (IRS) processed 245 million tax returns along with other types of tax forms.
With such a high volume of tax forms to process each fiscal year, the IRS looks for obvious discrepancies or red flags in tax returns that alert for suspicious tax evasions. Once a red flag has been found, the IRS further audits the tax return.
As a small business, the consequences of failing an IRS audit is severe. Not only would you have to pay additional tax or interest on tax penalties, you’d also have to refurbish tax documents (bank statements, invoices, etc.) related to the audit trail for the past two to five years. And in the worst-case scenario, if you fail to show your tax documents, your tax assessment could be considered fraudulent and you could face either three years imprisonment or $100,000 in tax penalties.
The good news is that you can avoid a tax audit, provided that you’re aware of potential IRS audit red flags. But identifying these red flags can often be difficult since small business face the key challenge of understanding their tax obligations.
A lack of understanding might lead you to file your taxes erroneously—underreporting your income, claiming large amounts of business tax deductions, not reporting cryptocurrency transactions, etc.
So how can you avoid an IRS tax audit? Using a tax software is one answer. Tax software automates the process of tax filing by helping you file taxes within the limits of IRS, thus avoiding any red flags.
Small businesses that adopt tax software as part of their digital transformation strategy will not only successfully avoid IRS audit red flags but will also be able to avoid costly tax penalties.
5 IRS audit red flags to look out for while filing taxes
With millions of tax filings to process each year, the IRS conducts a thorough audit of your taxes based on common audit red flags that highlight discrepancies in your income, deductions claimed, foreign assets, etc.
Your charitable donations exceed the 3% limit of adjusted gross income
Charitable donations feature as one of the most popular forms of tax deductions. Not only are you able to contribute more to a specific cause or charity, you’re able to increase your tax break.
However, there are limits assigned by the IRS to the amount you can donate to charities. These limits fall within the income range of any average taxpayer.
In other words, the IRS knows the average donations that taxpayers make in a tax year. If your donations exceed this average limit while tax filing, the IRS can flag you for further tax assessment.
- Keep receipts, bank records, and written communications with charitable organizations ready for your reference to avoid IRS scrutiny.
- While filing tax returns, clearly separate the value of cash donations from non-cash ones, as mixing the two can lead to IRS audit red flags.
Your income is underreported because of unintentional accounting entries
It’s a no-brainer that deliberately underreporting your income to claim higher tax breaks is an unethical accounting practice that leads to excessive IRS penalties.
And of course you’re not doing this deliberately!
But data entry errors while filing your tax return can creep in for a couple of reasons:
- A lack of understanding regarding your tax obligations, combined with not seeking expert financial advice to fill out form entries correctly.
- Common—and avoidable—human error.
Out of all the red flags, the IRS is specifically on the lookout for underreporting your income. It’s also the clearest one for the IRS to uncover, as it double-checks your reported income based on tax information retrieved from third parties (such as banks and employer records) and your tax return.
For example, the IRS’ Automated Underreporter (AUR) technology seeks out discrepancies by comparing your income information from third parties and your tax return. Once the AUR red flags a discrepancy, your tax case is forwarded to a tax examiner for further scrutiny.
After careful examination of third-party sources (banks and employer documents) that detail your income level, Notice CP-2000 is issued if the underreporting of income is genuine.
But don’t fret! Notice CP-2000 is just notification from the IRS to adjust your income, not a penalty. However, if after the notification the IRS finds discrepancies in tax audits the following tax assessment year, you could be additionally penalized.
- Ensure your income level is reported in the tax returns based on your bank statement and employment records.
- Use a tax software to avoid transposition errors while entering financial information in your tax forms that may lead to underreporting your income.
You fail to disclose your financial assets located abroad
The Foreign Account Tax Compliance Act (FATCA) makes it mandatory for businesses to report any financial assets that are located abroad during tax filing.
For example, if you have a bank account abroad, report it in your tax filing, as willful violation leads to IRS audit red flags and hefty penalties.
Even if you don’t disclose your foreign assets, the IRS is able to trace them through third-party foreign institutions that are mandated to account details of U.S. citizens.
U.S. citizens must report foreign assets in Form 8938 if the value of those foreign assets is above $50,000 ($100,000 in case of joint filing for married couples) while filing a tax return.
FATCA differs from FBAR (Foreign Bank and Financial Accounts), which is for reporting financial transactions abroad—such as in overseas banks accounts—that are worth more than $10,000. You don’t have to report FBAR along with your tax return, since it is filed as a separate form with the IRS, specifically for businesses with financial accounts abroad.
Filing the FBAR helps avoid IRS scrutiny in case you are required to show proof of your overseas bank accounts.
- To comply with FATCA, ensure all financial transactions are captured in your overseas bank account statements.
- Report all financial assets—including retirement savings, investments, partnerships, trusts, etc.—and not just your bank savings located abroad.
You mix business and personal expenses to claim higher deductions
Tax deductions help increase your tax break. However, the IRS keeps a close eye on excessive business tax deductions, as they might signal that you are mixing personal tax deductions (Medicare) with business (travel).
Moreover, the IRS knows what type of business may claim higher tax deductions by closely examining the occupational codes filled at the time of filing taxes.
For example, some businesses can claim higher business travel deductions within the permissible limit.
In addition, mixing business and personal expenses to claim a deduction gets tricky if you want to claim a home office deduction. In this type of tax deduction, you have to clearly stipulate square footage for your business versus your home in the tax form to segregate personal utility expenses from business expenses.
- Avoid claiming 100% tax deductions for business transport and meals.
- If you are self-employed with a home office make sure that you clearly segregate the home versus business deductions for expenses.
Your business engages in cryptocurrency transactions
The IRS has laid out clear guidelines for virtual or cryptocurrency transactions, which mandate that all businesses report profit gained from these transactions within their business revenue.
The IRS classifies cryptocurrencies such as BitCoin, Ethereum, Ripple, etc. as property for tax filing purposes. The agency’s Notice 2014-21 instructs businesses to clearly state the value of cryptocurrency transactions in terms of gain or loss while filing taxes.
However, cryptocurrency gains derived from selling coins are a part of your businesses capital assets. The IRS treats these assets as investment income and any gains made are treated as capital gains tax.
The IRS keeps an eye on the volume of trade that business actually does with cryptocurrencies. For example, even if you pay for a cup of coffee with Bitcoin as a business expense, you need report it in your tax filing since its a virtual currency transaction.
- Avoid high volume transactions with cryptocurrencies as that might alert the IRS for an audit.
- Avoid using cryptocurrency for general business expense transactions.
How tax software can help avoid IRS audit red flags
Tax software avoids the IRS audit red flags mentioned above, by conducting all tax transactions digitally. All your tax information is located in a centralized dashboard with the tax forms applicable to your business.
Key tax software features that can help you identify these red flags include:
- Reports management: From expense receipts, cheques to tax forms, a tax management tool helps you capture all relevant documents to file your taxes accurately.
- File taxes: Tax solutions help you file taxes based on your business tax obligations such as self-employed versus contractual workers, etc.
- Manage deductions for tax refunds: Tax tools help you to file every deduction within the tax limit of your business to avoid any potential red flags.
Next steps and additional resources
By now you may have a good idea for looking out IRS audit red flags while filing your taxes. As a next step, it is important that you use a tax management software (if you haven’t yet) to avoid IRS red flags. You can probably start using a trial version of the tax software just to test whether it meets your business requirements.