A small business tax audit is a common and unwelcome surprise for many business owners. Preparing for one can be difficult, stressful, and time-consuming. But, it shouldn’t be. If, as business owners, we are completely honest in our reporting, keep meticulous records, detailed expense reports, organize all receipts and payment slips, and log all related activities thoroughly, we can avoid most of the headache.

It’s important to stay in compliance with the Internal Revenue Service (IRS). If you don’t comply, you may end up paying more in taxes or even owe additional penalties and open yourself up to future audits. No one likes an audit. But with these tips, you’ll be prepared for the possibility and ready to navigate your audit with confidence.

Why am I being audited?

The reasons that might trigger an audit for your business can vary. The IRS looks at several factors when making sure your business is accurately filing and paying taxes. Here are some of the most common reasons:

• Claiming excessive deductions for things like meals and entertainment or other questionable expenses.
• Filing and paying your taxes late repeatedly.
• Sizeable reimbursed business expenses.
• Abnormally large charitable contributions
• Claiming 100% use of a company vehicle
• Running a cash-intensive business
• Claiming losses for several years in a row

Remember, auditors can look back as many as six years into your business records. Keep records for each year organized by year and category and stored in secure waterproof and preferably fireproof containers. Back up computer files on the cloud and external hard drives so no information ever gets lost.

Be honest

The first and most important step in preparing for a small business tax audit is to be honest. Just like with your personal income, honesty is indeed the best policy. Many people try to fudge numbers, exaggerate expenses, under-report income, or rely on guesswork for certain items. This sends up red flags for the IRS to come looking and sets a terrible precedent for inaccuracy and falsehood in your business dealings, something that has far-reaching consequences in many areas of life, not only your finances and reputation, but in your relationships as well.

What items should I bring to a small business tax audit?

When you receive notice of an upcoming tax audit, it is important to put together all necessary documentation. This includes all receipts, billing records, documents on purchases, income statements, payroll records, expense reports, and all other related documentation. Here is a short list of items to bring to a small business tax audit.

Bank Statements, Receipts and Canceled Checks

Your auditor will want access to all bank statements, for both personal and business accounts, all receipts related to every kind of payment or expense, and any canceled checks, invoices, or sales slips. If you pay cash for some expenses, save all paperwork, including notes, receipts, and cash vouchers.

Books and other Physical Records

If you keep formal bookkeeping and accounting records like ledgers and notebooks, your auditor will request these. This isn’t required by the IRS, but it can save you time and help keep you organized. If your systems are a bit less formal, like boxes of register tape and a checkbook, make sure these are on-hand, complete and in chronological order beforehand.

Electronic Records

If you do your bookkeeping primarily on a computer, either with software or cloud-based applications, you will need to provide the auditor with full access to all information through printed reports for anything they request. Make sure you’re doing everything you need every single day to keep your electronic records accurate and up-to-date.

Appointment Books, Schedules, Diaries, and Logs

These items will provide verification of your business appointments, meetings, travel, and other professional activities for which you might incur business-related expenses. Most of the time, business owners plan on claiming certain deductions based on expenses like travel, meals, lodging, auto, and more. Keeping as much information as you can, which verifies your expense claims, will help you both save money during tax season and move through the audit process with greater ease.

Keep Detailed Records & Stay Organized

We’ve discussed keeping all documentation and having it ready. However, in addition to having ready access to these, it is important that the information is complete and detailed. Document all income and expenses daily so you can easily account for them.

For example, try to be as specific as possible with your logging activities. If your business accepts cash, include the date, time, location, and who the transaction was with on your log sheet. If you accept credit or debit cards, then keep records of these transactions as well.

Keep invoices with every purchase made. This includes any furniture bought for your office space or supplies purchased for your factory. These receipts should be filed away neatly in order by date with corresponding details listed on them (i.e., vendor name, total cost of item/purchase, additional notes or arrangements).

Make sure to keep detailed records of both personal and business-related items. For instance, if you use your business credit card (with its company logo) for personal purchases like clothes or gasoline; keep those receipts. You will need to report this expenditure during the audit process because it’s considered a “double deduction.”

Be sure to carefully log all mileage driven by employees who are using their car for work-related purposes. Mileage logs must account for every mile claimed and should include dates and destinations. Consider keeping a log or book of appointments and schedules and notes about each one. This will let you link certain travel times and expenses with their corresponding events and meetings, allowing you to account for each mile or travel expenditure.

Report All of Your Income

No matter what kind of business you run, it is vital that you are reporting all income, both your own income/salary/bonuses, along with all employees and partners. Also, make sure records are precise when reporting revenue and profit figures for your business. Mistakes in these areas can cost you money, time, and credibility. Concealing any income will only come back to haunt you later, and may interfere with your ability to continue conducting business.

If you are self-employed, don’t forget about income from other sources, too. If you sell items on eBay or work gigs for friends, for example, list these on your tax return. The IRS has a multi-step process they ask people to follow in order to report all income accurately. These steps include:

1) Collecting all of your receipts and organizing them by category

2) Deciding what needs to be reported on the calendar year or fiscal year

3) Adding up the total amount of expenses incurred

4) Determining what type of business you are conducting (sole proprietorship, partnership, corporation)

5) Figuring out if you have any special considerations like depreciation or itemized deductions

6) Reporting all of this information correctly on your tax form

Review your Expenses

Expenses are a major part of a small business tax audit. In order to pass an audit, you should review your expenses to ensure that they are all accounted for and that you have the right documentation. The IRS will want records for every expense throughout the year. Make sure you label each receipt with the date, type of expense, and how much was spent.

You can use a spreadsheet or an online expense tracker to keep track of your expenses throughout the year. You might also find it valuable to keep a paper copy in your office as well as a digital copy on your computer or phone. You can never be too prepared when it comes to both business accounting and taxes. If you’ve been keeping receipts in a shoe box for years, now is a good time to organize them so they’re easy to find when it comes time for an audit.

Documentation is key to passing an audit, so make sure you save all receipts and documentation related to these expenses for at least six years after the date of purchase or last activity. That way, if there’s ever any question about what’s deductible, you will have everything you need on hand.

Understand Your Tax Code

One of the best things to do before a tax audit is to gain an understanding of your tax code. You can visit the IRS website or ask your accountant to help you identify which tax code category your business falls under.

There are four categories of business tax codes: Sole proprietor, partnerships, corporations, and S-corps. Sole proprietorships are taxed as if the owner is running their personal finances through their business. Partnerships are taxed as if there were two entities with one entity providing services and one entity receiving services. Corporations are taxed on the corporate level before any distributions are made to shareholders. And S-corps pay taxes on both the corporate level and at individual shareholder level after money is distributed to them by the corporation.

It is always wise to consult with a professional when needed, especially when preparing for an audit, or when you simply want greater organization and more control of your own bookkeeping. They can save you from costly mistakes and penalties and further headaches down the road.

Plan for the Unexpected

It is good advice for any area of life. We often only plan for trials when they are thrust upon us. It is far better to stay organized and prepare for eventualities ahead of time. This is why we purchase insurance for our homes, our cars, our businesses and ourselves. 

This is why we put up fences for security and a better roof for weather protection. Planning ahead when it comes to taxes and audits is a smart move. It will not only prepare you for your interactions with the IRS, but ensure that your bookkeeping is done with precision every single day.

Conclusion

There are many things to think about before your audit, but the most important are honesty, staying organized, keeping detailed records, and knowing your tax code. Audits may not be comfortable, but they don’t have to be something that completely throws us off track. The key is to think ahead, plan long-term, and operate your business and finances transparently and honestly. And never hesitate to connect with an experienced professional for help with your regular business bookkeeping needs, along with special help before and during an audit.

Sound Accounts is your all-in-one bookkeeping and payroll tax partner. We’ve helped businesses of all kinds manage their books successfully and make better decisions with increased awareness of their finances. Contact us today to get the help you need right when you need it most. 

For answers to questions about small business tax audits, check out our frequently asked questions below. 

FAQ

Why is my business being audited?

Reasons for an audit vary widely from business to business. Yet, the most common include Claiming excessive deductions for things like meals and entertainment or other questionable expenses, filing and paying taxes late, sizeable reimbursed business expenses, large charitable contributions, claiming 100% use of a company vehicle, running a cash-intensive business, claiming losses for several years in a row, and other reasons. 

What should I remember when preparing for an audit?

First, be honest about everything, your income, expenses, profits, contributions, wages, and every other financial matter. This will keep your business above board and ensure you don’t run into trouble with the IRS. 

Throughout the year, keep detailed records of everything, if possible, both in hard copy as well as on the computer or in the cloud. Make sure to have full access to electronic accounting files, receipts, expense reports, invoices, payroll, checkbooks, ledgers, notebooks, bank accounts and any other financial reports or pieces of accounting evidence for up to six years back from the current year. 

Can bookkeepers help me with an audit?

Yes, definitely. Bookkeepers and accountants are not only helpful when preparing you for your audit, since they are deeply involved with your bookkeeping from day to day, but they are able to get you organized and up-to-date on everything so you have a much better chance of not being audited in the first place.