No one wants to run afoul of the IRS. Few situations can invoke as much angst as an IRS audit. Although, none really come to mind at the moment. An IRS audit is the result of the IRS wanting more information from you. There are various reasons why an IRS audit may be triggered. The best practice is to be completely honest and transparent. Here’s how you can avoid future ruins with the IRS.
What is an IRS Audit?
An IRS audit occurs when the IRS wants to review or examine a taxpayer’s financial information. This often occurs because the IRS believes there is a discrepancy in the information provided in individuals’ tax returns. The IRS conducts audits through the mail and in-person interviews.
Mail audits will typically result in a letter being sent out with a request for more information like income information and expense tracking. If your books are shotty, the IRS might follow up with an in-person interview. If you receive a letter from the IRS requesting more information, make sure you respond in a timely manner.
What Can Trigger an IRS Audit?
The IRS audits to catch taxpayers cheating on their taxes, and they watch for red flags to decide where to focus their efforts. Oftentimes, audits stem from simple mathematical errors, typos, or reporting mistakes. In those instances, you can usually resolve the audit with a simple fix to your return.
However, the federal tax authorities will nail you to the wall if they suspect you’re purposely withholding information. A full-blown audit is a nightmare, so you should do your best to avoid suspicion. Here are some of the most common IRS red flags:
Underreporting your income is a no-go for the IRS. If you receive a 1099 form, the IRS gets a copy too. You can also land yourself in hot water for underreporting income from other sources, like securities trading and gambling.
The IRS is particularly sensitive about cryptocurrency trading income as of late, so take extra care to report your profits accurately if you’re a trader.
Deductions can be a taxpayer’s saving grace when it comes to saving on taxes, however excessive use of deductions can warrant extra attention from the IRS. If you have a lot of deductions, be sure to maintain immaculate records in case the IRS wants to take a deeper look.
Consecutive Annual Losses
You can deduct business losses, but the IRS will get suspicious if you report three or more consecutive losing years. The IRS tends to look into businesses that claim losses for more than three years.
If you consistently miss filing deadlines, you could find yourself on the wrong end of an audit. Filing your return late attracts IRS scrutiny, so file your returns on time with the rest of the heard to avoid undue attention from the taxman.
How Far Back Can the IRS Audit?
The IRS typically can audit records going back as far as three years, and they can go back six years if they suspect major fraud. However, there is no specific statute of limitations for tax fraud, so the IRS has the legal authority to audit ancient history if they want. A commonly held rule of thumb says to hold onto receipts and financial records for at least three years to ensure you will have evidence to defend yourself if the IRS comes knocking.
Other Enforcement Action
Audits aren’t the only weapon in the IRS arsenal. They have a variety of tools to get back at shady filers, including:
Fines, Penalties, Interest
The IRS imposes fines and penalties for delinquent tax bills. Usually, the penalties add up to a monthly interest penalty ranging from 5% to 25% on the outstanding balance. If the IRS audits you, you have 21 days to pay your new bill. The IRS will assess an additional 0.5% penalty if you miss the post-audit deadline.
The IRS issues CP2000 letters when they believe a taxpayer omitted some of their income. It’s not nearly as serious as an audit, but the IRS is sending you a strong message. If you received a CP2000 letter, the IRS probably thinks you earned more than you stated on your tax return. If that’s the case, you owe more money than you claimed, and the IRS wants its dough. This is the part where you shove your meticulous financial records in their face and prove them wrong if it’s a mistake. It’s another demonstration of why keeping accurate records is so important.
The IRS has the ability to take your money before it even touches your hands. If your tax bill is in collection attempts and you’re avoiding the IRS, the government will deduct money from your paycheck to cover the outstanding balance. Wage garnishment, also known as IRS wage liens, can impact your paycheck for 11 to 25 weeks.
Your property is subject to tax liens if you fail to pay your tax bill in full within 10 days after the IRS notifies you. Tax liens alert creditors that the government has a legal right to some or all of the undersigned property. A tax lien can last up to 10 years under the statute of limitations law.
How to Avoid an Audit
As with most things, the best defense against an audit is to prevent it in the first place. However, you can do a few things to protect yourself from a worst-case scenario:
Maintain Organized Records
Good record keeping is paramount when it comes to audit defense. In the event the IRS wants more information, having accurate records that back up your tax returns is crucial. This could be expense tracking, income tracking, and even customer tracking. For example, when claiming business meals as a deduction, you should note the meeting attendants and topic of discussion along with the financial info.
Keep Receipts for 3 Years
As we mentioned above, the IRS typically goes back as far as three years when conducting an audit. Maintain receipts for a minimum of three years so you can defend yourself in case the IRS has questions.
Don’t Abuse Deductions
Excessive deductions are an IRS red flag. You’re entitled to deduct legitimate expenses, however, the IRS might want to take a second look at your return if you go overboard. Always play it by the book, and only claim qualified deductions.
File/Pay Your Taxes on Time
Avoid unnecessary fines, penalties, and scrutiny by filing your taxes on time. If you can’t file on time because you are missing information, request an extension before the deadline. Short on cash? Set up a payment plan before the due date to avoid major penalties.
Don’t File a Paper Return
If it’s feasible, you should always e-file your taxes. E-filing is efficient, secure, and free, so there’s no reason not to give it a shot. If you mail your tax return, any number of things could cause an issue. Your return could get lost, delayed, or even stolen by an identity thief.
Your return goes straight to the IRS when you e-file, and it leaves a digital trail proving you filed on time. The IRS prefers electronic returns, so some experts believe they’re more likely to audit paper returns
Hire a Professional Bookkeeper
Outsourcing your bookkeeping can be a huge help. This can help you stay organized, and compliant, and ensure that your bookkeeping duties are being performed. One of the biggest mistakes is that your books get neglected. This can happen when you are busy running your own business and trying to do everything yourself. A bookkeeper can help with invoicing, collections, and bills in addition to helping you prepare for your taxes.
The decision to outsource your bookkeeping can be one of the best decisions you make for your small business. Accurate bookkeeping is really important when it comes to audit defense. Questions or concerns? Click here to schedule a one-on-one strategy session with a Shared Economy pro today! For more tax tips subscribe to our newsletter below.