The IRS announced in late 2020 that it will increase tax audits of small businesses by 50 percent in 2021. At a time when many small-business owners are still scrambling to find relief from the coronavirus pandemic, this is likely the last news entrepreneurs wanted to hear. Fortunately, even though tax audits sound scary, there are solid strategies businesses can put in place to eliminate tax mistakes and avoid an audit this year.
Good record-keeping is key.
Solid record-keeping is a small business's best defense against an IRS audit. This defense is two-fold:
- Good records prevent you from making mistakes in reporting gross receipts (revenue) and tax-deductible expenses.
- Essential small business tax documents provide justification and proof of your income and deductions to the IRS.
A quality bookkeeping system also saves you time and headaches when taxes are due. Depending on your business, this system might include accounting software, employees, or a third-party tax professional.
Whatever you choose, make sure this system is easy to use and tracks all of your transactions reliably. Being audited is never fun, but it's most painful and expensive when you don't have the records you need.
Use deductions correctly--and explain unusual expenses.
As business owners, it's tempting to try to deduct as many expenses as possible. But auditors look closely for missteps with business deductions--and an unusual itemized deduction (even if correct) can be a red flag that spurs further inspection.
Deductions are incredibly useful for small businesses and, as a leader, you'll often be motivated to maximize them. However, to avoid an audit, you'll want to ensure that this portion of your return has been prepared with immaculate accuracy.
Make estimated tax payments on time.
Small businesses made up of individuals--such as sole proprietors, partners, or S corporation shareholders--will need to make estimated tax payments if they expect to owe $1,000 or more in taxes when they file their return. Similarly, corporations should make estimated payments if they expect to make $500 or more. Missing these payments can put you at risk of an audit.
Don't rely too much on independent contractors.
Independent contractors often play an important role in small-business growth. However, the IRS has specific rules about when a team member must be classified as an employee, rather than as a contractor.
Generally speaking, the difference depends on the type of control the business has in the relationship. With independent contractors, the business controls the outcome of the work, but not how the work gets done. In contrast, businesses typically have greater input into how employees perform their work, pay for expenses, and interact with the company--including whether the relationship is long-term.
Having a high ratio of independent contractors to full-time employees can trigger an audit because businesses can use contractors to avoid paying payroll taxes.
Know the rules for Covid-19 tax changes--and in general.
Many of these tax changes interact or overlap. For instance, businesses that received PPP loans cannot claim employee retention tax credits. However, they did have the option to defer Social Security taxes.
Because of this, navigating the U.S. tax code is likely to be more challenging in 2021 than it has been in prior years. The best thing small-business owners can do to ensure their tax returns are accurate is to prepare early. Get your tax records in order and meet with your accountant to review key deductions and any coronavirus-related tax changes that have affected your business.
While no one likes thinking about the possibility of a tax audit, some prior planning can help you avoid this risk and get back running your business.