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. 

When you’re a small business owner, it’s natural to want to know all the ins and outs of the tax code. But sometimes you have so many expenses that it’s hard to keep track of which ones can be written off. As a result, you may miss out on deductions that could add up over time. In this article, we’ll go through several of the most common expenses for small businesses and help you decide which ones are worth taking a closer look at.

Which expenses can a business owner deduct?

With such a staggering array of expenses, it isn’t easy to know which of them can be deducted, what you should focus on to save the most money, and how to do it correctly. Here are 14 expenses you can deduct from your taxes.

Utilities: Unlike the rules governing personal taxes, which do not allow deductions for these personal expenses, utilities such as electricity, gas, oil, water, trash and telephone bills, can usually be deducted for businesses. With the amount most businesses pay annually on these resources, it pays to keep track of your numbers and look for this deduction.

Insurance: The majority of businesses take out some form of insurance, if not several. The cost of health coverage for the business owner, as well as business continuation insurance are deductible. Other types of deductible insurance policies include liability coverage, property insurance, malpractice, worker’s compensation, auto insurance on company vehicles, and employee life insurance paid for by the company. When it comes to health insurance, a small business may qualify for up to a 50% tax credit under the qualified small employer health reimbursement arrangement (QSEHRA).

Rent on Business Property: If you rent your business property, you may deduct your rental payments or lease from taxes. If you run your business from home, you can do an eligibility test with the IRS to see if you are entitled to any deductions based upon home use. Certain types of deductible home business expenses include insurance, utilities, mortgage interest, repairs, and depreciation. There are specific rules to abide by and limitations that apply when calculating expenses and deductions as it pertains to the use of your home for business purposes. To learn more, see IRS Publication 587. And whenever questions arise, consult with a qualified accountant for answers.

Auto Expenses: If you have a car specifically for business, you can usually deduct anything considered a car expense such as payments, fuel, repairs and insurance. You must keep records that prove business usage and record mileage. You can rely on the IRS standard mileage rate, which is $0.58 cents per mile.

It is important, though, to keep in mind that if you use your car for both business and personal purposes, you need to divide your expenses based upon actual mileage used for each purpose. You may refer to IRS Publication 463 for more information regarding travel, entertainment, gift, and car expenses.

Office Supplies: Boxes, paper, pens, pencils, paper clips, staplers and staples, copier and printer ink, you name it. All these costs may be deducted from taxes.

Office Furniture: Furniture is generally considered an office supply, so can therefore be deducted as a qualified expense. 

Travel Expenses: If, as a business owner, you are frequently on the move, it is worth researching this deduction. Types of deductible expenses include airfare, lodging, tolls and taxis (UBER & Lyft). Certain limitations apply: You must be away from the area or city where you regularly conduct business and you must be away from your tax home for more than a full workday.

Employee Salaries: Usually, your employee salaries are tax deductible, including bonuses and commissions. These deductions, however, do not apply to sole proprietors, LLC members and partners, as these members are not considered employees.

Advertising & Marketing: If you can prove it is directly related to your business, you may deduct regular advertising and marketing costs, including business cards, billboards, print and digital ads and more. It also includes contracting individuals to design logos, write copy for content marketing, write scripts for video ads, or design and implement any other marketing or advertising tool.

Interest: If you have one or more business loans, you’re making interest payments. Those payments are usually tax deductible as long as you’re using the entire loan strictly for business purposes. To qualify, it must be a traditional loan through a lender, like a bank or credit union. It can’t be a personal loan from a friend or family member. The business owner must also be legally liable for the debt.

Contracted Labor: If you use independent contractors as part of your workforce, you can deduct compensation made to these individuals. To do so, you must issue a form MISC-1099 to any contracted worker making over $600 (cumulative annually), and a 1099-K if they are paid by credit card or with PayPal or similar apps.

Legal and Professional Fees: Whether it’s an attorney, a team of lawyers, or a professional accountant, you can deduct 100% of these fees.

Rent and Depreciation on Equipment and Machinery: If you lease equipment for your business, you can deduct these costs. Whether it be office machines like fax, phone, computers, monitors, copiers and printers, transport vehicles like trucks and vans, or heavy machinery for production or farming, you can take advantage of this deduction. You must deduct it over the course of several years. You need to claim a Section 179 deduction. This allows business owners to deduct up to the limit of $1,050,000 and a maximum value of $2,620,000 for property during a single tax year. For many businesses, this can be a significant deduction, given the volume of equipment many companies use.

Start-up and Organizational Costs: To be honest, this one isn’t actually a deduction. The IRS sees start-up costs as a capital expense. They are viewed simply as an investment since the money invested hasn’t left the business; it has merely been transformed into an asset. Capital expense deductions are usually calculated over several years. This is called amortization. This enables businesses to accurately assess their profitability. For specific information on this process and your possible savings, see IRS publication 535.

This is not an exhaustive list. There are many more deductions available to business owners. Take time to study your options. Seek information from the IRS and meet with an accountant to discuss all your options. It is important that you file correctly when claiming deductions and that you don’t miss out on additional savings. A qualified accountant can make sure you’re covered.

What are some things you can’t deduct from your taxes?

Gifts: This one is mixed. You can deduct the first $25 of gifts to clients. After that point, there is no deduction.

Regular Commute: Mileage incurred while driving to and from your regular place of business cannot be deducted. However, there are a few exceptions. You must have a qualifying home office and be forced to commute each day to a temporary mobile workstation/location outside of your metropolitan area. This exception is decided upon on a case by case basis by the IRS. You must consult a tax professional for more information.

Penalties and Fines: You cannot deduct the cost of fines and penalties, even if you incurred them during business activities. Sorry, no breaks for parking and speeding tickets, or other similar penalties.

The importance of documenting everything and keeping receipts

When it comes to your business expenses, it’s important to keep thorough records. This will help you if you ever have to dispute your deductions for any reason, whether it be during an audit or in hopes of getting approved for a loan. Plus, maintaining complete records ensures you have the best chance of tax savings. Keeping meticulous records can seem like a hassle at first, but it will actually make things easier down the line because you’ll know exactly what the IRS needs from you.

These days, there are so many programs that help us keep track of our expenses much easier than we used to. From QuickBooks Online and Xero, to apps like Evernote and others, many programs allow you not only to enter your figures manually, but even take photos of receipts and categorize them. Whether you box up your receipts or take photos of each one, make sure you have a visual record of them all.

The importance of quality accounting professionals during tax time

When it comes to finding and understanding every possible tax deduction, one of the most important investments is to hire a great accountant. When you hire an accountant, they’ll be able to keep track of your income and expenses, but they’ll also be able to save you money by catching mistakes and helping you reduce your tax bill.

They also help you spot patterns and make better, more strategic decisions about the direction of your business. It’s vitally important for small businesses to have a quality bookkeeper or accountant who can handle the complicated process of filing taxes correctly and helping the owner manage their finances with confidence.

Conclusion

Business tax deductions can save you a lot of money. And there are a lot of them to make use of. Study up, consult with a tax professional and hire an experienced accountant to get the most out of your deductions.

Sound Accounts can help you get the most out of your business tax deductions. We help business owners from every market sector understand all their tax options, save money, manage their accounting, and make the most of their resources. Reach out to us today for the accounting and tax support you need.  

For quick info about small business tax deductions, check out our frequently asked questions and answers below. 

FAQ

Why is it important to understand business tax deductions? 

There are countless expenses involved in running a business. Many of them provide you with the possibility of tax savings, sometimes significantly. It is important to have a firm understanding of these, both so you can save the most money possible, and so that you file everything correctly to avoid costly errors. 

What expenses can I write off?

There are too many to list here. But they include rent, utilities, equipment and machinery, travel expenses, interest payments on loans, office supplies, salaries, contracted work, legal fees and much more. Both the IRS and a qualified accountant will help you better understand how to navigate the world of business tax deductions. 

How do I make sure I’m filing my taxes correctly?

The best way to ensure accuracy is by hiring a qualified accountant. They will help you make sense of your expenses, find every possible deduction that might save you money, and educate you on what to do in the future to stay organized. 

Many people took the opportunity to start their own small businesses in 2020 and 2021. During the heart of the pandemic, a record 4.4 million new businesses were created. Up significantly from an annual average that has rested around 600,000 per year for the past quarter century. Nearly 32 million small businesses currently operate in the United States. If you were one of those new business owners or sole proprietors in the past few years, or you are looking to start a new business in 2022, the idea of working from a home-based office is an attractive one.

Many new business owners start out by working from home and the great news is that many home office supplies can be deductions for your small business. But what is and is not eligible to be written off on your taxes? As a home-based business owner, do you know what you are allowed to expense? Do you know what counts as an office expense deduction? Let’s review some broad categories for home office expenses and break down what is allowed and what to avoid when filing home office deductions for your small business.

Home Office Deduction

The home office tax deduction applies if you use a specific portion of your house regularly and exclusively for your business. This is mainly based on the honor system, but here are a few examples that you can think about when deciding how the home office tax deduction applies to your unique business set-up.

If you have a room that is used solely for your home office, such as a second bedroom that is not used for anything other than your small business activity, then that would qualify for your home office deduction because it is a dedicated space for your business. However, if you have that spare room set up as an office but occasionally work from your dining room table, you could not also include the square footage of your dining room to increase the deduction for your home office expenses. The dining room is obviously used for activities outside of business purposes. 

Another example would be independent contractors who are able to do all their business from their laptops and choose to work from their kitchen table. In that case, it is going to be impossible to quantify the use of the whole kitchen as an acceptable home office deduction. A kitchen will never be seen as a principal workplace or dedicated space for business because it is impossible to prove that it is used exclusively for your business. So not only do you need to prove that the space is used to run your small business on a regular basis, you also need to prove that the space is not used for any other purposes.

There are also two different ways to go about quantifying the home office deduction and calculating the office expenses for use of the space; the regular option and the simplified option. With the simplified version, rather than deducting expenses you’ll calculate the square footage of your space and multiply it by the rate of $5 per square foot up to 300 square feet of space. This means that, at a maximum, you would get a $1500 deduction for your home office.

With the regular option, you’ll value your home office tracking the actual expenditures of the space against your total home expenses. To do this, you’ll have to add up allowable deductions including mortgage interest, taxes, maintenance, repairs, utilities bills, insurance, and other related expenses. Then you’ll calculate the percentage of those expenses for the size of your home office. 

The simplified method is obviously easiest, but you should consider going with the standard method if your home office space is significantly larger than 300 square feet or if you feel that your home expenses and utility bills would put the deduction value of your home office above $1500. Your tax preparer can help you understand which of these methods will be best to track the legitimate deduction for your small business.

There are also a few exceptions that relate to specific types of business owners, one example being if you provide day care services or run a daycare facility from your home. Another example is that you use part of your home for the storage of inventory. If you have a significant amount of inventory and product samples in storage in your home, you can potentially use this exception. Check with your tax preparer prior to tax season to see if there are any exceptions that could apply to your home office space.

Internet and Phone Deductions

If you work out of a home office, some of the most common types of expenses you could deduct are your internet services, telephone service, and fax bills. For a home-based business, those are easy to quantify as a tax-deductible expense. However, you can only count an office expense deduction that is directly related to your business. This means you can’t expense the entire cost of your home phone and internet bills simply because you work from home; to be a legitimate business deduction it has to be related to the running of your business. 

It can be tricky to figure out what was purchased for personal purposes and what are deductible home office expenses for business-related activity. The easiest way to manage this is to either add a second phone line to your home, or get a cell phone to use exclusively for your business. Otherwise it will be very difficult to determine what calls were made for personal use vs. what calls related to your home-based business. 

Similarly, it can be challenging to know how to deduct a portion of your internet expenses. What you can consider is the cost to build, maintain, and manage your business website. Those are reasonable expenses to deduct if you use a website to manage your current business. 

Office Supply Deductions

To be able to deduct office supplies you have to prove that they are ordinary and necessary business expenses, and not materials for personal use. So a printer that is stored in your home office space and not used by anyone else is an acceptable expense, whereas a printer that is used by all members of your family (for example, your kids use it for homework) is not going to be approved as a home office deduction.

Likewise, if you do a school supply run for your kids at Target and decide to grab some office supplies for yourself at the same time, it is going to be a challenge to itemize what you purchased for household use and what you purchased for yourself in order to submit an itemized deduction of office supplies.

An easy way to get around this is to use your business bank account for appropriate office supply expenses. That way your receipts and bank records will already be separated from family expenses and household budgeting and you will have an easier time identifying your business purchases. If you are trying to estimate your business taxes, it is much easier to identify appropriate business tax deductions if you are only looking at your company’s bank account. Maintaining accurate records and separating your personal expenses from your business expenses is always recommended, especially for home-based business owners.

The best way to keep track of all potential tax deductions is to have an excellent bookkeeping system in place to keep detailed records of all your business transactions. Sound Accounts  provides bookkeeping, payroll, and licensing services. Whether you have a small business or sole proprietorship, and whatever stage your small business is at, we can work with you to provide accurate accounting and payroll support. Contact us to learn more about how we can serve you!

For answers to some standard tax deduction questions, check out our frequently asked questions below:

FAQ’s

What is a home office deduction?

According to the IRS, a home office deduction allows qualifying taxpayers to deduct certain home expenses on their tax return if they run a small business or do work for their small business from home.

What qualifies for a home office deduction?

There are many home office deductions that you may qualify for. The biggest one is usually deducting a specific amount for the physical space that you use in your home for small business operations. There are both simple and standard options for calculating the amount of deduction for your home office space.

Are there limits to what I can expense or deduct for my home office?

Yes, there are some strict stipulations for what you can expense. To get the deduction for the use of a physical space in your home, it has to be a space that is used exclusively for your small business. For office supplies, again they must be used exclusively by you for the management of your small business. There are a few highly-specific exceptions to these limits, so check with your tax preparer to ensure that you are getting all the deductions that your small business may qualify for in 2021.