What happens if your business gets audited?

So, you got that dreaded letter from the IRS. Your heart sinks, and your mind races. What now? An IRS audit isn’t just a random check; it’s a detailed examination of your financial records to ensure everything adds up. And yes, it’s as stressful as it sounds, especially if you don’t have all your receipts.

As a small business owner, keeping your finances in order should be high on the priority list. While there could be a number of worries on your mind, getting a notification that you’re going to be audited by the Internal Revenue Service (IRS) is sure to cause some level of stress. You may not have the resources to have a full-time bookkeeper or accountant on staff to manage your business accounting. That means you may be handling everything yourself or only use an accountant once a year. If you think the IRS is singling you out, think again. As you start making more money, the IRS tends to look at your business a little more closely. And as your business income and assets increase, the IRS starts paying more attention to your business dealings.

Why Would the IRS Want to Audit Your Business?

There are a few reasons why the IRS may want to take a look. These reasons are called audit triggers and can start the tax audit process for even the most legitimate business. Here are some practices that might trigger a small business tax audit:

Deductions for Entertainment and Meals

If your business is taking a tax deduction on everything, the IRS could flag some of these events or items as unnecessary, prompting them to pay you a visit. The IRS considers it a huge red flag when meals and entertainment expenses are super high.

Home Office Deductions

With so many people working from home now, it’s not uncommon to have home office deductions. The problems start when the business deductions for working from home are very high. You should have a designated space within your home that is solely for business. You should also be able to accurately report the square footage of the space used as a home office.

Rounding Off Numbers

If your tax return keeps coming up with round numbers instead of exact figures, the return may get flagged because it may seem as if you’re guessing instead of reporting real figures.

Failing to Report Corporate Employee Salaries

If you are being taxed as a C- or S-corporation, you should be receiving a reasonable salary before any non-wage distributions are made. If you’re filing Form 1120-S and don’t have an entry for officer wages, or wages that are questionably high or too low, you may be getting a call.

Year-Over-Year Losses

The whole point of having a business is to make money. If your business continues to only lose money and does not show any gains, the IRS will start thinking you’re co-mingling funds.

Not Reporting Taxable Income

This is a huge red flag. You must pay taxes on everything, even your accounts in other countries. If you’re neglecting to report income, the IRS will have no problems going after you.

Sole Proprietorships

When you’re a sole proprietor, it’s easy to co-mingle funds. The IRS wants to see the division of assets to make sure you’re not hiding money or double-dipping.

Cash-Based Businesses

Do you operate your business solely with cash? These types of businesses are heavily scrutinized because it is very easy to hide income when you only deal with cash.

Types of IRS Audits

Understanding the type of audit you’re facing can help you prepare better. The IRS conducts different kinds of audits, each with its own process and level of scrutiny.

Correspondence Audit

This is the most common type of audit. The IRS sends you a letter requesting additional information or clarification on specific items in your tax return. It’s often resolved through mail.

Example: You claimed a significant amount in charitable donations. The IRS asks for proof, like receipts or bank statements, to verify these donations.

Office Audit

An office audit requires you to visit an IRS office with your documents. It’s more detailed than a correspondence audit and usually focuses on specific areas of your tax return.

Example: If you claimed a home office deduction, you might need to bring receipts for home expenses, mortgage interest, and utility bills.

Field Audit

The most comprehensive type, a field audit, involves an IRS agent visiting your home or business. They review your financial records thoroughly.

Example: A small business owner might face a field audit to verify income, expenses, and payroll records. The agent might even interview employees.

What Happens When a Business Gets Audited?

The IRS will send correspondence in the form of an audit notice advising you of the upcoming audit. From the moment you receive the letter, it’s important to start gathering everything you need. IRS auditors dig into everything, taking note of any discrepancies or questionable items that may result in you having to pay penalties, additional taxes, and interest.

Here’s what you will need:

Bank Statements

Bank statements are very telling – they indicate what money has come in and gone out and paint a true picture of the transactions that have taken place. You will need to provide business bank statements and your personal bank statements as well.

Receipts

This is where a lot of business owners go wrong. Receipts are essential to keeping track of your business activities. If you haven’t started scanning them, or you can’t get an electronic copy emailed to you, now is the time to start putting this into practice (before you get audited).

Electronic Records

Business credit card statements, online financial records like those from PayPal, Stripe, Zelle, and Venmo all play their own part. If these apps have been used for business purposes, the IRS wants to know.

Vehicle Records

If you have made claims or deductions on your vehicle use for mileage, wear and tear, or anything else, you will need to provide a full maintenance history of your vehicle. You will be reporting when it was used, for which business purpose and the dates must coincide with what you have reported.

What Happens if You Don’t Have Receipts During an Audit?

Missing receipts? You’re not alone, but you’re also in a tight spot. The absence of receipts can lead to several consequences, and none of them are pleasant.

Potential Consequences: Penalties and Fines

Without receipts, the IRS may disallow your deductions, leading to:

• Additional Taxes: You’ll owe more taxes because your deductions are disallowed.
• Penalties: The IRS can impose penalties for underreporting income.
• Interest: You’ll owe interest on the additional taxes from the date they were due.

How IRS Determines Income Without Receipts

The IRS uses various methods to estimate your income and expenses if you lack receipts. They might:

• Bank Deposits Method: Examining your bank deposits to estimate your income.
• Net Worth Method: Comparing your net worth at the beginning and end of the year to estimate income.
• Expenditure Method: Looking at your spending patterns to estimate income.

What Happens After the Audit?

There are three outcomes that can result from your small business audit:

The Information is Reported as Being Correct

This is by far the best outcome. The auditor finds that everything is accurate and in order on your tax return and you won’t face any penalties, additional taxes, or interest.

A Mistake Was Found, and You Agree with the Auditor

If the auditor finds errors and you agree with them, you may be on the hook for paying additional taxes, penalties, and interest on the amount due. The error found may also be in your favor, which means the IRS will be refunding your business money.

A Mistake is Found, and You Don’t Agree

If this occurs, you can disagree with their findings and file an appeal. You have 30 days to file. If you are still not satisfied, you have every right to file suit against the IRS.

How to Reconstruct Lost Receipts

Lost your receipts? Don’t panic just yet. You can still reconstruct your financial records and provide acceptable proof to the IRS. Here’s how.

Bank Statements

Bank statements can serve as a solid backup. They show the date, amount, and merchant for each transaction. While not as detailed as receipts, they can help substantiate your expenses.

Example: If you lost a receipt for a business lunch, a bank statement showing the transaction at the restaurant on the same date can support your claim.

Credit Card Statements

Credit card statements are another valuable resource. They provide similar information to bank statements and can be used to verify purchases.

Example: Misplaced the receipt for office supplies? Your credit card statement listing the purchase at an office supply store can back you up.

Supplier Invoices

Reach out to suppliers for duplicate invoices. Many businesses keep records of their transactions and can provide you with copies upon request.

Example: If you bought inventory for your store but lost the receipts, contact your supplier for copies of the invoices.

Affidavits

In some cases, affidavits can serve as proof. These are sworn statements detailing the expense, signed and notarized.

Example: For cash transactions where no receipt is available, an affidavit explaining the expense, date, and amount can be useful.

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Tips for Avoiding Future Audits

No one wants to go through an audit again. Here are some practical tips to help you avoid future audits and keep your financial records in order.

Keep Detailed Records

Meticulous record-keeping is your best defense against audits. Keep all receipts, invoices, and financial statements organized and accessible.

Example: Use folders or digital tools to categorize receipts by month and type of expense.

Use Accounting Software

Accounting software can streamline your record-keeping and reduce errors. Tools like QuickBooks or FreshBooks can track expenses, generate reports, and store digital copies of receipts.

Example: Homebase offers integrated tools that can help manage payroll and time tracking, ensuring your financial records are accurate and up-to-date.

Regularly Review Financials

Conduct periodic reviews of your financial records. This helps catch discrepancies early and ensures everything aligns with your tax returns.

Example: Set a monthly reminder to review your bank statements, credit card statements, and receipts.

Consult a Tax Professional

When in doubt, seek expert advice. A tax professional can help you navigate complex tax laws, identify potential issues, and provide guidance on best practices.

Example: Schedule an annual review with a CPA to ensure your tax filings are accurate and compliant.

How to Handle an Audit Notice

Got an audit notice? Don’t freak out. Here’s what you need to do to handle it efficiently and minimize stress.

Respond Promptly

Time is of the essence. Responding quickly shows the IRS you’re cooperative and can help resolve the audit faster.

Example: If you receive a correspondence audit letter, reply with the requested information within the specified timeframe.

Gather Documentation

Collect all relevant documents to support your tax return. This includes receipts, bank statements, credit card statements, and any other financial records.

Example: For a home office deduction, gather utility bills, mortgage interest statements, and receipts for office supplies.

Contact the Auditor

Communication is key. Reach out to the auditor assigned to your case to clarify any questions and understand what’s required.

Example: If you’re unsure about a specific request, call the auditor to get more details and ensure you provide the correct information.

Seek Legal Representation

In complex cases, hiring a tax attorney can be beneficial. They can represent you, negotiate with the IRS, and provide expert advice.

Example: If the audit involves significant amounts of money or potential legal issues, a tax attorney can help protect your interests.

Best Practices for Audit Preparation

Preparing for a potential audit might seem daunting, but following best practices can make it manageable. Here’s how to stay audit-ready.

Organize Records Annually

Annual organization of your financial records ensures everything is in order and easy to find.

Example: At the end of each year, categorize your receipts, bank statements, and invoices by type and date.

Review Tax Returns with a Professional

Having a tax professional review your returns can catch errors and ensure compliance with tax laws.

Example: Before filing, have a CPA review your return to verify all deductions and credits are accurately reported.

Stay Informed About Tax Laws

Tax laws change frequently. Staying updated ensures you’re compliant and aware of any new requirements.

Example: Subscribe to tax newsletters or follow reputable tax blogs to keep abreast of changes.

Perform Self-Audits

Conducting internal audits can help identify and correct issues before the IRS does.

Example: Quarterly, review your financial records and compare them to your tax return to ensure consistency.

Having your finances in order is smart business sense. That’s why using an all-in-one system like Homebase can keep your records in one place, making sure everything is carefully documented, taxes are paid, and you won’t have any worries.

The Homebase payroll features make things painless, with organization at the forefront for your payroll, taxes, compliance, timesheets, and more. The burden of trying to figure it out by yourself doesn’t have to be your reality anymore. From payroll to HR and more, you can have it all – in one place, with Homebase.

Need help figuring it out? Homebase Payroll puts everything at your fingertips through the desktop or an employee-accessible app. We’re ready to help. Sign up today!