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Receiving an IRS audit letter can be a nerve-wracking experience for any business owner. An IRS audit is an examination of the information you’ve reported on your tax return. While it’s crucial to understand that an audit doesn’t necessarily mean you owe more taxes, it can lead to tax adjustments if you can’t provide adequate proof for the items in question.
Understanding IRS Audits
Before I dive into the tips, let’s briefly understand the types of IRS audits:
- Correspondence Audit: This involves simply mailing in documentation to the IRS. There’s no in-person contact between you and the IRS. One typical correspondence audit is the CP2000 Notice:
- A CP2000 notice is a notice telling you that the income, deduction, or credit you reported on your income tax return doesn’t match what third parties (employers, banks, and others) reported (Forms W-2, 1098, 1099, etc.) to the IRS and the IRS is proposing an adjustment based on the information received from those third parties.
- Office Audit: This type of audit is a face-to-face meeting at the IRS office or over the telephone.
- Field Audit: Here, an IRS agent visits your business, home, or representative’s office for an in-depth examination.
The Importance of Reporting 1099-MISC or 1099-NEC Income
When a business pays income to individuals, sole proprietors, limited liability company (LLCs), or partnerships totaling $600 or more, the business is required to issue a Form 1099-MISC or 1099-NEC. Unfortunately, not all third-party companies provide these forms promptly or accurately. It’s crucial to understand that regardless of whether you receive a 1099 from a third party, it’s your responsibility to keep track of all income and expenses. There are no excuses when it comes to IRS compliance.
An IRS Audit Letter, such as a CP2000 Notice could be mailed within the first 3 years of opening your business because you omitted 1099 income or other transactions on your tax return. If you have, CALL NOW (786) 212-1803.
Recognizing the Risk: Why Your Business Might Face an Audit Within Its First 3 Years
The IRS operates under a statute that allows them three years to assess additional taxes on a filed tax return. This period is referred to as the Assessment Statute Expiration Date (ASED). This clock starts from the original return received date or the due date of the original return, whichever is later. If you fail to report more than 25% of your income, the ASED can be extended to six years. However, there’s no statute of limitation for unfiled or fraudulent returns. To minimize your risk of receiving an IRS Audit Letter in the initial stage of your business, consider these 12 valuable tips:
1) Set Up a Business Bank Account
The only expenses that could be on your personal account are the:
- Research phase
- Initial legal and accounting fees to start the business
- Incorporation fee
As soon as you incorporate your business with the state and obtain an Employer Identification Number (EIN) with the IRS, set up a dedicated business bank account with a credit union or regular bank such as Chase Bank. Mixing personal and business finances can complicate your record-keeping and raise red flags during an audit.
BONUS: Make sure the minimum monthly checking account balance is maintained so no interest and penalties are charged.
2) Set Up a Business Credit Card with Rewards
The same day you open the business checking account, apply also for a business credit card at that credit union or bank such as Chase Bank Credit Card. Use a business credit card for expenses and choose one with rewards and no annual fee. This keeps your business with cash for an additional period since card payments are made one month later. It not only helps with expense tracking but also accumulates rewards you can reinvest in your business.
BONUS 1: Don’t let your rewards expire, redeem them.
BONUS 2: Pay the full amount so no interest is charged.
3) Contribute Capital to the Business or Loan the Business Money
For expenses that can’t be covered by a business credit card, and funds are not available in the business checking account, make capital contributions or loans to the business. Write a personal check from you to the business and deposit that in the business account. Ensure proper documentation and terms are in place.
BONUS: Whether a loan is from you or a third party, get it in your name. Then create a promissory note between you and the business for the money you will loan it stating the following:
- the date of the loan,
- the loan amount,
- the maturity date,
- term of the loan (1, 3, 5, etc. year),
- repayments frequency (monthly, annually, etc.,) and
- the interest to be charged.
4) Get an Online Accounting System
Invest in an online accounting system like QuickBooks Online to track all your financial transactions. It simplifies record-keeping and helps prevent errors.
5) Subscribe to a Payroll Provider
If you have employees or independent contractors, use a reputable payroll provider such as QuickBooks Payroll or ADP, to deposit taxes, manage tax filings accurately and on time. A payroll provider can also assist with setting up any retirement plan, such as 401K and individual retirement account (IRA) options that are appropriate for your business, which can defer and/or reduce your taxes.
The negative effects of not using a payroll provider
- A business who failed to file or filed inaccurate W-2 or 1099 can be penalized. This penalty accumulates over time. IRS Notice 972CG, (Notice of Proposed Civil Penalty) penalties are both:
- per Form you didn’t file and
- the number of individuals you didn’t issue a form to.
- Trust Fund Recovery Penalty can be assessed on employers and responsible parties who withheld taxes (social Security, Medicare and Income tax withholding) from an employee’s paycheck but failed to deposit it with the IRS.
- Misclassification of employees classified as independent contractors because employer doesn’t want to file and pay employment taxes, can also result in penalties.
With a payroll provider, the chance of these happening is reduced tremendously.
6) Track Your Vehicle Mileage with Apps
If you use your vehicle for business purposes, use mileage tracking apps to record your travels. QuickBooks Online has a mileage tracking app in all its levels of subscription. This ensures you can claim the mileage deduction accurately.
Calculate Total Mileage for Year
- At the beginning and end of the year, record the odometer reading, and
- Uploaded vehicle service receipts will show the odometer reading for that date.
7) Take a Picture of Your Home Office
If you have a home office, take pictures as proof for tax deductions. Except for daycares, to qualify as home office, it must be used exclusively for business. Calculate your home office’s square footage to claim the deduction correctly.
8) Set up a written Accountable Plan
Strictly segregate personal and business expenses. If you have expenses that are both personal and business, set up an accountable plan for reimbursement. To offer an accountable plan, an employer must comply with all three IRS standards:
- The expenses must be for a business activity.
- Receipts and/or documentation must be provided within a reasonable period to validate expenses, and
- The employee must return any advance payment not spent to the employer within a reasonable period.
Some expenses that qualify under an accountable plan are
- Travel expenses (either actual or per diem).
- Gas or mileage expenses (either actual or per diem).
- Other vehicle expenses (tolls & parking, insurance, repairs, car wash, etc.)
- Home office, including depreciation and many more.
Pay these with your personal funds and provide the employer with the proper documentation for reimbursement. Personal expenses should never be paid through business accounts.
9) Store and Backup Documents Online
Secure your documents and receipts by storing them in a cloud-based storage system. This protects against physical disasters and keeps your records organized.
BONUS: Use a password with letters, numbers and symbols and change it continuously (quarterly, semi-annually or annually).
10) Invest in a Waterproof and Fireproof Safe
For essential physical documents, invest in a waterproof and fireproof safe. This provides an additional layer of protection in case of emergencies.
BONUS: If your safe operates with batteries, be sure to purchase spares. However, don’t put them inside the safe, because that would defeat the purpose.
11) File and Pay Your Tax Return on Time
Don’t attempt to file your business tax return yourself. Estimated taxes could be scheduled for monthly payment to spread the cost out or on the quarterly payment due date. Hire a certified public accountant or an enrolled agent to ensure accurate and timely filings.
Who should pay the tax
Income Taxes are paid on form 1040 for:
- S-Corporation (1120S) or partnership (1065): 1120S or 1065, Schedule K-1 flows on Form 1040, Schedule E
- Sole proprietor or single-member LLC: Form 1040, Schedule C
Income taxes shouldn’t be on your financial statements, but on your personal accounts. If you don’t have the funds in your personal account, do the following:
- Take the money from your company through a distribution.
- Have your company write you a check for the amount of the tax owed.
- Deposit the check into your personal bank account.
- Pay your 1040 income tax.
Distribution in S-Corporation or Partnership with no basis
If you take more cash or property distribution than you have in your company, you will have to pay capital gains tax. So before taking any distribution, make sure you have basis.
12) Keep a Copy of Your Tax Return for at Least 7 Years
Maintain a copy of your original tax return and all supporting documents for at least seven years to protect yourself in case of future audits.
Running a business efficiently involves more than just providing excellent products or services; it also requires meticulous financial management. By following these 12 tips, you can significantly reduce your risk of receiving an IRS audit letter and ensure that your business remains on solid financial ground.
Remember, timely compliance and accurate record-keeping are the keys to a successful and audit-free financial future.
If you’ve received an IRS Audit Notice or need assistance with any tax-related issues, don’t procrastinate. I specialize in tax problem resolution and can help you navigate the complexities of IRS audits and other tax matters. Let’s discuss your options and find the best solution to resolve your tax problems.
Author Bio: I, Ergedine, am the president of Ergedine Pericles, CPA, P.A. I have been in the accounting industry for over 20 years. As a certified Public Accountant, my goal is to relieve you of your stress from IRS tax problems by not just resolving the problem but also educating so the problem doesn’t occur again.