What can small business owners do to avoid an audit?

If there's one thing that's sure to get every small business owner's heart pumping, it's a piece of mail from the IRS. Maybe you accidentally paid too much and you're getting a check back? It's possible, but it's more likely a request for more information or to review your books. In other words, an audit.

Audits aren't always a reason for concern, but even a straightforward audit could be a time-consuming nuisance, so it's best to avoid it altogether if you can.

What is an audit?

Before diving into the different ways small business owners can lower their chances of getting audited, it may be helpful to understand how and why an audit can occur.

There are actually four types of IRS audits:

• Correspondence audits. Most audits are correspondence audits, where the IRS has a few questions about your tax return and sends you a letter. Dealing with a correspondence audit could be as simple as sending proof that what you claimed is correct. For example, sending receipts to back up the expenses you claimed. Here's a list of the types of records the IRS could request.
• Office audits. In some cases, you may receive a letter requesting you visit the nearest IRS office for an in-person audit. Be prepared to answer questions about your tax return, and bring in all your supporting documents.
• Field audits. IRS agents may visit your home or business during a field audit to verify that your tax return is correct, review your records, or ask your staff questions. For example, the IRS agent might verify that the space you claimed as a home office is actually being used as an office.
• Taxpayer Compliance Measurement Program (TCMP) audits. The TCMP audit may be the most complex, as it involves going line by line through your tax return and verifying everything is correct. These audits are generally conducted on a small group of randomly selected tax returns, and there isn't much you can do to avoid them.

Who gets audited?

Aside from the random TCMP audits, audits usually occur when the IRS suspects something might be incorrect in a tax return. However, it's not as if someone is closely reviewing your tax return.

"The IRS simply doesn't have the manpower or budget to have a revenue agent manually look over every single tax return, says Logan Allec, a CPA and owner of the personal finance blog Money Done Right. "The IRS uses a proprietary computer program called the Discriminant Inventory Function System (DIF).

The DIF system assigns each tax return a score based on what's being claimed in the return. If your tax return has a high score, an IRS revenue agent might take a closer look. Additionally, you could be audited if your records don't match the records that the IRS received. For example, if another business claims it paid you money that you didn't report as income.

Overall, for the 2016 tax year, only 0.5 percent of tax returns were audited, and most of those (about 70 percent) were correspondence audits.

Five potential red flags that could trigger an audit

Certain things may increase your tax return's DIF score (and, subsequently, the chance that you get audited). If one of these situations matches your own, don't feel pressured to change your return and skip deductions. Claim all the deductions you're entitled to - just remember to keep records of everything.

1. You claimed you primarily use your personal vehicle for business

Many business owners use their personal vehicle for business purposes. Perhaps you're traveling to different clients, job sites, or offices. "You can certainly deduct your vehicle expenses as a legitimate tax write-off, says Allec.

However, the IRS also asks whether you have another vehicle for personal use and may be suspicious if you claim you only have one vehicle and use it for business most of the time. Of course, that could be the truth.

"If you're being honest, you have nothing to worry about, says Allec. However, if your claim triggers an audit, you'll need to have evidence to back up your mileage deduction. "It is absolutely essential that you keep a mileage log to prove the miles you drove during the year.

2. You claimed a low salary from your S corp

S corporation business owners who are also employed by their business must pay themselves a reasonable salary for their work as an employee. They can then take the remainder of the company's profits as an owner's distribution, which isn't subject to FICA taxes.

"One of the most common audit triggers for S corporations is a too-low salary amount, says Allec. "The problem is that many S corporation owners set their salary at a certain amount years ago when they first started their business, but as their business grew, they didn't update their salary amount.

To ensure you have a reasonable salary, you may want to check Glassdoor or Salary.com to see how much someone in a similar position at a different company could earn. You don't need to do this every year, but if your business has grown for a few years in a row, it may be time to give yourself a raise.

3. There was a large change in your income or expenses

It's reasonable for a business to experience a period of rapid growth or a rough patch. But sometimes, a big change might flag an audit. For example, if your business expenses suddenly double or triple without an increase in your revenue, that might be a red flag. "It just looks funny, says Allec, "especially from the standpoint of an IRS computer that is programmed to flag anomalies.

4. You mixed personal and business expenses

You're allowed to deduct your business' expenses from your revenue, but you can't deduct any personal expenses. Before you file your tax return, make sure you're not misclassifying an expense.

Some common areas of confusion include:

• Home office deduction. You can only claim the home office deduction if you use an area exclusively for your business and it's your principal place of business. A guest room that doubles as an office doesn't qualify.
• Meals. You can't claim your regular work lunches as business expenses, although you can claim half the cost of meals if you're having a business lunch with someone else (who doesn't work for your company) or if you're traveling for business.
• Entertaining clients. You used to be able to deduct expenses for entertaining clients (or potential clients), such as the cost for sports tickets. However, this deduction was eliminated by the Tax Cuts and Jobs Act of 2017.

5. You forgot to report business income

"It's imperative for you to double check not only the expenses you're claiming on your tax return but also the top line, says Allec.

The IRS should get copies of the tax forms you receive, including 1099-MISC and other income-related forms. These get tied to your business, and if you don't include these forms (and the corresponding income) when filing your return, that could be a red flag.

What to do if you get audited

Perhaps you did everything right and still got audited. Don't worry, it happens.

Allec shares the next four steps you should take if you receive a correspondence audit:

1. Remain calm.
2. Read the notice.
3. Call the number on the notice, ask the IRS agent for more details, and take notes. Keep a record of the person's name and identification number.
4. Respond to the request by mail or fax as soon as possible.

"Talk to a tax professional for anything beyond a correspondence audit, says Allec. "Unless you've been through an audit before, it's probably best that you get a professional in your corner to help you out.

Funding Circle believes informed consumers are better consumers. We strive to provide informative and educational content useful for you and your business. However, please note that tax laws and regulations are complex and subject to change. We strongly recommend consulting your financial or tax professional regarding your specific circumstances.