What Real Estate Businesses Can Do To Avoid IRS AUDITS
Audits become more inconvenient than terrifying if you learn how they work. Let’s start with explaining an audit, then move on to strategies to avoid getting audited—and how to make the process go more smoothly.
What is an audit?
When the IRS audits your business, they look at all of your financial records. That includes double-checking your financial statements to ensure they match your bookkeeping.
They usually want to make sure you aren't underreporting your income or overreporting your deductible expenditure. In either situation, you'd be claiming a lower tax liability than what you actually owe.
What happens when you get audited?
An audit can go one of three ways:
- The IRS finds out you don’t owe them any money, and leaves you alone.
- The IRS finds out you owe them money. You sign an official document, confirming the amount you owe. Then you pay up.
- The IRS finds out you owe them additional tax, and you dispute it. In this case, you’ll want the support and expertise of a tax lawyer, an enrolled agent, or a CPA. Depending on your argument, the IRS will either reduce the amount you owe, make you pay the full amount, or throw out the charges altogether.
What triggers an audit
It’s almost impossible to anticipate an audit. But they’re triggered for one of three reasons:
- Random selection through the IRS system
- Computer screening—returns that fall outside the IRS “norms” are flagged
- Related examinations—if your tax return is connected to another taxpayer who is being audited, you may be audited just by association
Small business signals that could trigger an audit
While no there’s no magic eight ball for predicting audits, if you’re doing one of the following, you increase your chances of bringing one on:
- Failing to report income that has already been reported to the IRS (on W2s or 1099s). You could be accused of tax evasion
- Taking suspiciously big deductions—for instance, deducting 100 percent of your personal car use. You could be accused of tax fraud
- Misclassifying your employees
- Failing to issue information returns—W2s, 1099s, etc.
The different ways you can be audited
In the movies, a group of cool IRS officers kicks through your door and ransacks your office. Your business buddy takes a private jet to the Cayman Islands. Your accountant goes to the bathroom and locks himself in. Your secretary has resigned.
An audit doesn't look like that in real life. (However, the IRS may perform a field audit in certain circumstances.)
More commonly, an audit fits one of three formats.
- Correspondence audit. The IRS will ask for further information over email or physical mail. Usually this is caused by an omission of income, or another serious error. You’ll either have to pay the amount detailed in the correspondence, dispute it with a lawyer, and/or provide the necessary documents such as receipts for deductions, or missing W2 forms.
- Office audit. The IRS may want to interview you in person. You will have to go into the IRS office. It’s wise to bring along a CPA or a lawyer. You may end up paying more in taxes or penalties, or if you dispute it, you may not have to pay at all.
- Line-by-line audit. This is chosen at random. The IRS goes through each line of your tax return so they can establish the “norms” that trigger future audits.
Don’t worry, though. As long as you comply (or legally dispute), provide sufficient proof where necessary, pay the fines, and demonstrate that you did not have criminal intent, you will be fine.
How to prevent an audit
There’s no foolproof way to avoid an audit. But, if you do the following, you can definitely reduce the likelihood you’ll be subjected to one.
Account for all of your income
The IRS compares the income and deductions you record on your tax return with information supplied by others, such as employers, banks, and businesses, using the information on Forms W2, 1098, and 1099. Any disparities in reported income numbers that result in tax underpayment are a clear red flag for the IRS. It'll almost certainly lead to more investigation.
If you have a side hustle, such as consulting or freelance work, make sure to report it, even if you think you can get away with it.
Double check your return
One of the simplest ways to ensure a visit from the tax man is to make a negligent error on your tax return.
The IRS is required to investigate your case if there is any omission, miscalculation, or error on your return. Engage the services of a bookkeeper to ensure that your books are accurate and tax-ready. Bench can not only help you with your books, but can also help you with your taxes.
Stay consistent with your accounting method
You can choose between two accounting approaches as a business owner: cash basis or accrual accounting. If you alternate between the two approaches, the IRS may believe you're attempting to deceive them. This will trigger an audit.
Whatever accounting approach you choose for your company, make sure you stick to it.
Keep it straight—employee or contractor
It's critical to correctly designate workers as employees or independent contractors when you recruit help. Which taxes must be paid, when they must be paid, and who must pay them are all determined by this distinction.
You must withhold income taxes and pay unemployment, social security, and Medicare taxes as an employee in most cases. You don't have to withhold or pay taxes on an independent contractor's wages.
What is the statute of limitations for tax auditing?
Typically, the IRS has three years after you file a tax return to audit you for that tax year. There are a few exceptions, however.
Significantly underreporting your income
If you’ve failed to report more than 25% of your gross income, the IRS has up to six years to audit your federal tax return. This also applies if, by other tax maneuvers, you pay the equivalent of what you’d pay if you underreported 25% of your gross income.
Omitting foreign income
If you fail to report $5,000 or more in foreign income—for example, cash stored in an offshore account—the IRS statute of limitations extends to six years.
Failing to file IRS Form 5471
If you have ownership in a foreign corporation, and you don’t report the fact with Form 5471, the statute of limitations extends indefinitely. That means you could undergo an IRS tax audit for any return you’ve ever filed.
Never filing, or filing a fraudulent return
The statute of limitations runs indefinitely if you've never filed taxes or if the IRS believes that one of your filings is fake. Even if you made a mistake, such as failing to sign your tax return or mistakenly changing the “penalties of perjury” text at the bottom of the return, you could face a fraud penalty.
How to make an audit easier
Nobody likes to consider the worst-case scenario. However, by taking the appropriate precautions now, you can make a tax audit less traumatic in the future.
There are two things you can do to make the thought of an audit less frightening.
1. Maintain organized records
Keeping your small company documents in order will make it much easier to substantiate whatever the IRS asks you about.
The distinction between a hobby and a business is one that the IRS frequently examines. The IRS states that if you have an activity that isn't classified as a business, your "allowable deductions cannot exceed the gross receipts for the activity." This is known as the "hobby-loss rule."
Maintaining correct accounts and using financial records to support the legality of your declared profit margin can assist you in demonstrating that you are running a legitimate business rather than claiming tax deductions for your personal macramé workshop.
2. Separate your personal and business expenses
The IRS requires business owners to keep their personal and business finances separate. Unless your company is a sole proprietorship, you must keep your business and personal finances separate in order to comply with the law.
The corporate veil is pierced when expenses are commingled. If your firm is liable for any outstanding obligations, creditors, including the IRS, might pursue your personal assets.
If your personal and business spending are currently mingled in the same account, register a small business bank account as soon as possible and separate your spending.
Having all of your business spending in a designated business bank account will make dealing with a tax audit much easier, in addition to providing an extra layer of legal separation between your personal and corporate assets.
IRS penalties and fines
So, you've made a mistake when it comes to submitting your taxes. Perhaps it was discovered as a result of an audit, or perhaps you forgot about it during tax season and arrived late.
Don't worry—unless you had criminal intent, you're unlikely to get arrested or have your small business seized.
The IRS tax penalties for the most common non-criminal infractions are shown below.
Penalties for missing a deadline
Filing your taxes late
To begin, you can always request a tax extension.
However, if you submit your taxes more than 60 days after the due date or extension date, the minimum penalty is $205, or 100 percent of your outstanding amount if you owe less. That is, assuming you file within 60 days of the 60-day deadline.
If you don't file for another month, you'll be fined 5% of the unpaid tax for each month you don't.
Even if you are aware that you will not be able to pay your payment in full, you should file your taxes and pay what you can. The IRS interest accumulates quickly.
Paying your taxes late
You will be required to pay an extra 0.5 percent of unpaid tax each month until your initial tax bill is paid in full, up to a maximum of 25% of your entire tax debt.
Be aware that even if you mailed in a check on time, but it bounced, you will still be subject to this penalty.
Combined penalty for filing late and paying late
Thankfully, these two penalties don’t stack. If you are late to both, you will only pay the 5 percent per month interest fine.
Paying your taxes late, after an Issuance of Notice
If the IRS discovers that you owe more in taxes than you estimated, they will send you an Issuance of Notice to request the additional payment. After then, you have 21 calendar days to pay the difference, after which 0.5 percent interest per month will begin to accrue.
Submitting a form late
A punishment of up to $50 can be imposed if you are late in filing a W2 (for employees) or a 1099 (for contractors).
The penalty for failing to file a 1065 form (for partnerships) or an 1120S form (for S-Corps) on time is $195 per month per partner.
Penalties for making a mistake
Calculating your owed taxes too low
The penalty is a 20-40 percent increase in taxes owed if you considerably understate how much tax you owe or the IRS decides you were irresponsible in an area of your taxes (i.e. it wasn't just a tiny mistake).
Calculating employee taxes incorrectly
All unpaid federal employee taxes are subject to a 100 percent penalty. In other words, you'll have to pay the employee taxes twice because you didn't pay them the first time. Not reporting employee salary through your payroll provider and not reporting employee tip money are two frequent circumstances.
When does it become criminal?
If the IRS determines that your error goes beyond carelessness and into the realm of knowingly lying, submitting a false return, and violating tax laws, you have committed a criminal act and may face property seizure or jail time. The Internal Revenue Service isn't messing around.
It's like getting hit by lightning when you're audited. You don't want to practice pole vaulting in a thunderstorm just because it's unlikely. Making sure your records are accurate and your taxes are filed on time is one of the best strategies to keep your head down during tax season.
We are here to help at SRG Advisors -- CPAs Jay Guttmann, Leon Schenker, and Milton Rosenblatt are experienced professionals who strive to help businesses operate more efficiently and confidently. Our firm, SRG Advisors, LLC, provides accounting and tax services to many businesses in Hackensack, Teaneck, Fort Lee, Paramus, and the surrounding communities.
Schedule a call with us at 201-525-1222 or email us at info@srgadvisors.com