Debunking Common Myths about Tax Audits

May 10, 2011

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There are many misconceptions about what can trigger an IRS audit - a bogeyman of many business owners - and how to minimize your chances of suffering one.

Getting audited by the IRS is generally something everyone tries to avoid, but not everyone knows about the criteria that can lead to an audit or how to prevent business taxes from drawing suspicion. There are several myths about what increases the chances of a business audit, as well as a variety of real factors that can actually influence the likelihood of raising a red flag at the IRS. Here we look at the real and imagined causes of audits, as well as ways to reduce the odds of being targeted for one.

"There's nothing that strikes fear into the heart of a small business owner like getting an audit notice. The chance of being audited in any given year is small: About 1 percent of 2008 taxable returns were audited," Bloomberg BusinessWeek notes. "But self-employed individuals and small business owners are more likely to be audited than employed persons, particularly if they report adjusted gross income of more than $100,000."

The Myths Public perception of the auditing process is often loaded with rumors and anecdotal evidence. The mystery is partly due to the IRS's algorithm for calculating differences between a return and a model representing similar returns. A common misconception is that receiving a notice from the IRS about a problem with your return will lead to an audit; however, approximately one in 20 field audits results in no changes to a return, and some of the changes that do occur can be in the taxpayer's favor.

Another common myth, according to BNET, is that e-filing a return will set off red flags. In fact, returns submitted electronically are less likely to have arithmetic errors, which are a common auditing trigger, and can thus reduce the likelihood of an audit. Many people also think that an amended return can cause problems and they consequently act against their better interests.

"This may be the most unfortunate trigger myth, because it could convince someone due a refund not to claim it for fear of baiting the audit ogres," BNET explains. "Go ahead and claim it...as long as you can back it up. The amended return won't by itself increase your chances of audit."

Some believe that filing for an extension on a tax return increases the chances of an audit, but, in fact, the opposite may be true. Returns that arrive later in the season may actually be outside the "quota window" that IRS agents supposedly employ during tax time.

"Some accountants theorize that the quotas get filled well before the tax extension deadline in October (or September for business tax extensions). Thus, when the tax returns which have been approved for extensions are finally submitted, the IRS agents have less incentive to put those returns in their audit pile," tax extension advisory FileLater explains. "There is some discussion as to whether or not this is true, but filing a tax extension certainly won't single you out for unfavorable treatment."

The Reality Myths aside, what are some of the real reasons that a tax return can trigger a business audit? According to entrepreneurial and small-business consultant Rhonda Abrams, the amount of income you declare is a major factor. An adjusted gross income of over $1 million a year has a 5.6 percent chance of being audited, compared to 2.9 percent for income over $200,000 and under 1 percent for those making less than $200,000.

Likewise, hiding any of your business's income makes you a prime target for an audit. If your company deals mostly with cash, the temptation may be to "ignore" some of that income, but you should avoid doing so. The IRS looks for such inconsistencies and doesn't tolerate them.

Mixing your personal expenses with your business expenses is also risky. Remember that you can only deduct 50 percent of your company's entertainment and food expenses, and don't attempt to write off anything like a personal vacation or a lavish party. You're also less likely to be audited if you use a separate personal car rather than relying on a company car for all your traveling.

Making math errors or inputting the wrong I.D. numbers can easily trigger an audit. For this reason, filing electronically might be a smart move, as there are less than 1 percent of errors in e-filing compared to nearly 20 percent on paper returns. Moreover, an e-filed return with a math error won't be accepted and is instead sent back for correction and resubmission.

Filling out certain forms or schedules in your tax return can greatly increase your chances of receiving a business audit, making it important to know which documents to file and which to avoid.

"Some optional forms and schedules virtually guarantee an audit. For example, if you turn a hobby into a sideline and show a business loan, the IRS may question whether some of your deductions are legitimate. If that happens, you might file a Form 5213, which keeps the IRS from auditing you for the first five years of the business," the Wall Street Journal reports. "If you can show that you're profitable in at least three of the years, then the business isn't a hobby and the losses in the other years aren't questioned. The problem: Filing the form virtually guarantees an examination at the end of five years."

According to the Journal, filing a Schedule C (as the sole proprietor of a business) makes you 10 times likelier to be audited than if you incorporate your business and file under S corporation status. Although incorporating a business can be costly, it does provide greater personal liability protection and decreases the chances of being audited in the future.

For information from the IRS on tax auditing and how to prepare for an audit, click HERE.

Earlier: Year-End Tax Tips for Small Businesses

Resources

How to Handle a Tax Audit by Karen E. Klein Bloomberg BusinessWeek, March 11, 2011

Tax Audit Trigger Myths: What Won't Bring the IRS to Your Door by Mark Henricks BNET, April 11, 2011

Does a Tax Extension Increase Your Chances of a Tax Audit? FileLater

Top 9 Small-Business Tax Audit Triggers by Rhonda Abrams RhondaOnline.com, April 3, 2009

10 Ways to Avoid a Tax Audit by Barbara Weltman The Wall Street Journal, Jan. 24, 2011

IRS Audit FAQs IRS.gov, Sept. 23, 2010

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