The Internal Revenue Service (IRS) is a United States Government agency, responsible for the
collection of taxes and enforcement of tax laws. It was established in 1862 by President
Abraham Lincoln. The agency operates under the authority of the United States Department of
Treasury and its primary purpose include the collection of individual income taxes and
employment taxes. It also handles corporate, gift, excise, and estate taxes, including mutual
funds and dividends.
Plenty of business owners, be it a sole proprietor, a limited liability company, etc., dread
receiving any letters from the IRS. This article will serve as a basic guide, listing some of the
triggers that you should keep in mind, in order to avoid getting audited by the IRS.
What is an IRS Audit?
The IRS may choose to review taxpayers’ accounts and financial information to ensure all tax
laws and regulations are being followed. Even though the IRS only audited 0.4% of individual
income tax returns in 2019 (according to U.S. News), many taxpayers live in fear of receiving a
letter from the IRS questioning items on their filed tax returns.
One factor to keep in mind is, the IRS has up to three (3) years after the tax filing deadline to
initiate an audit, or up to six (6) years if you omit 25% or more of your income.
1. Income
The first and perhaps the most common category that results in an audit trigger is related to
income. Fewer than 1% of tax returns with $200,000 or less in income are audited. This
percentage tends to rise to 10% or higher for those earning above $1 million. This obviously
does not mean that you should try and earn less, it is just a factor that tends to attract the IRS’s
attention.
The second factor related to income is understating/overstating your income. Either way, if
there is a difference between the income you filed on your tax returns versus the income that
your bank account/books show the IRS will definitely notice and call your attention because of
the discrepancy.
2. Excessive deductions
Whether they be home office deductions or others, the IRS will compare itemized deductions
to the average total deductions for a given item claimed by other taxpayers, who are in the
same income range as you. Any taxpayer who exceeds such averages by a certain margin will
attract scrutiny from the IRS.
3. Claiming 100% Business use of a vehicle
The IRS is aware of the fact that it's extremely rare for someone to use a vehicle they own,
100% for their business purposes. If you do not have another personal vehicle registered under
your name, it is almost impossible to report one vehicle is solely being used for business
purposes. The higher percentage that you claim, the critical it is for you to have detailed
records.
4. Claiming the loss on a hobby
Writing off expenses for a business is okay; but you have to be careful when it comes to
portraying your hobby as a business, whether you’re breeding dogs or trading cryptocurrency!
For it to be a proper business, you must have a reasonable expectation to make a profit. A
general rule of thumb is, the IRS will expect you to report a profit for 3 of every 5 years that you
operate the business. If you report your hobby as a business, it must be run like a business
along with proper documentation and records.
5. Reporting excessive business losses
The IRS enables people to deduct plenty of expenses throughout their business operation.
However, the IRS also wants to make sure that you are not running a questionable business
purely with the intention of benefitting from those deductions. It is natural for businesses to
incur losses in certain years, however, when the business has never made a profit, this may
definitely put a red flag to the IRS.
6. Unreported stock trades
Although not every business owner participates in trading stocks, if you have been trading in
stocks, regardless of whether you made a profit or a loss on them, you need to report it to the
IRS, otherwise prepares for an audit.
7. Owning a cash-only business
Operating a mostly cash-based business, where other entities do not issue you 1099 for your
services can raise a red flag for the IRS. It is not a matter of, the IRS is after you specifically, but
the agency will look at your income versus your expenses and will also take into account your
lifestyle. In simpler terms, if you are driving around in a Ferrari but only report an income of
$50,000; such situations create the perfect conditions for an audit!
8. Foreign assets
This is not applicable to everyone, but if you have a foreign bank account or other foreign
assets, it will raise your chances of being audited by the IRS.
9. Claiming excessive charitable donations
This does not mean the IRS is against charity, but the agency has its limits. If you are claiming
excessive charitable donations on your annual returns, the IRS will surely take notice and issue
you an audit letter. This does not mean that you have to steer clear of charity, it just means that
you need to keep your records and documents straight and in order and as detailed as possible.
10. Simple errors
Simple errors, although individually, might seem minimal can amount to a lot at the end of the
year. Whether you decide to round up a figure or just mistakenly write an extra 0, the IRS will
surely take notice. If your business is growing, it is best to seek the expertise of tax
professionals to help you report everything properly to prevent an IRS audit which will
definitely be a horrific situation to be at.
Conclusion
Receiving an IRS letter does not mean it’s the end of the world! The above list, although not
exhaustive gives you certain factors that you should consider next time you’re filing your tax
returns.
Moreover, it is recommended that you hire tax professionals, such as “Wycotax” to do them for
you.
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