The Merriam-Webster Dictionary defines an audit as a complete and careful examination of the financial records of a business or person. US tax payers and tax preparers commonly define it as a headache.
An audit costs the IRS money, so it’s no surprise they will focus on returns that offer a better potential to increase tax liability if a change is indeed made. Income level does not necessarily mean you will, or won’t, be audited. In the past:
- Higher income brackets (1 million and above) have been audited at a rate of 10.85%
- Income below a million but above $200,000 are audited at a 2.7% rate
- The majority of filers claiming below $200,000 are being examined at a rate of 0.88%.
These rates are just an average. There are better key indicators for who might be selected for audit.
When facing an IRS audit, the focus is on how to provide information to assure the highest accuracy, especially in areas that might be red-flags to the IRS, such as not reporting sources of income or questionable deductions.
The IRS has many ways of knowing what sources of income a filer has and at what amounts. A W-2, 1099, and many other familiar tax statements are part of a matching-program within the IRS that allows them to target filers who earn income but are not reporting it on their returns. They also key in on cash intensive incomes because they know it is less likely to be reported accurately. The goal is to report your income entirely and accurately while claiming appropriate deductions.
Some deductions are red-flags on many small businesses, so it is important you keep accurate and complete records on them. The IRS might question a vehicle reported as used 100% for business but no personal vehicle is reported. Small businesses are also scrutinized on their meals, entertainment and travel deductions as these deductions have stricter substantiation requirements that are often not met.
If your business had losses for a few years straight this may call into question whether it is a business or hobby. A hobby loss is not deductible, so you want to avoid having your business classified as such. You need to provide substantiation that your business is continually invested in growth and becoming profitable. Accurate and complete records will substantiate your claims.
The IRS holds a massive amount of financial information for filers small to large, in every industry and geographical location. They track where the largest misreporting has occurred historically and are charged with the responsibility to identify it today. Lower than actual income and higher than actual deductions claimed effect key financial ratios used to help them find problem reporting. You should not need to worry about these ratios if you’ve taken proper precaution in your reporting, substantiate your amounts, and generally keep accurate and complete records.
If you have any questions about this topic or need assistance, please request a complimentary accounting consultation with one of our CPAs or contact us at (616) 642-9467.