Welcome to Part 2 of our 12-part series on how to legally reduce your income tax burden. Here in Part 2, we going to allay fears you may have of being audited by the Internal Revenue Service (IRS).

While failing to plan ahead for taxes (the subject of Part 1 of this series) is probably the No. 1 mistake small business owners make, letting the threat of an IRS audit discourage you from claiming certain deductions or credits is a close second. Here at Stees Walker & Company, we encourage clients to claim every legally allowable deduction and credit. Failure to do so leaves money on the table — our clients’ money — and that’s something we just can’t tolerate. The fact is, your chances of being audited are slim.

However, we encourage you to assume you will be audited. What?

On its surface, that advice may strike you as a contradiction, but it’s really not. Assuming you will be audited simply calls for documenting all income and expenses, so in the event your business is audited, you have the documentation needed to prove your case. In other words, respect the IRS, but don’t fear it. Today’s historically low audit rates make it pay to be aggressive in claiming deductions and credits, but they is no excuse for careless accounting and record-keeping.

Afraid to Raise Red Flags?

As a taxpayer, chances are good that, at some time, you chose not to claim a deduction or did not claim the maximum you’re allowed because you were afraid “it would raise a red flag.” The fact is, audit rates are so low, most legitimate deductions simply aren’t likely to raise any red flags. Audit rates hit an all-time high in 1972 at one for every 44 returns the IRS received. But lately they’ve dropped to historic lows. According to the IRS, for 2019, the overall audit rate was just one in every 220 returns, or 0.45 percent of all returns.

Roughly half of those hinged on one issue — the Earned Income Tax Credit for low-income working families. The rest of the audits focused mainly on returns filed by small businesses — especially sole proprietorships and businesses that have plenty of opportunities to hide income. Examples? Single location restaurants and laundromats. (The IRS publishes a whole series of audit guides you can download from its web site that tell you exactly what they’re looking for. Each guide focuses on a specific industry or type of business, such as “Child Care Provider,” “New Vehicle Dealership,” and “Cash Intensive Businesses.”)

Just changing your business’s legal structure can dramatically change your odds of getting audited. For example, in 2015, the IRS audited 2.31 percent of Schedule C businesses reporting gross income topping $100,000. Yet for that same year, they audited just 0.2 percent of partnerships and S corporations, regardless of how much they earned. That suggests you can cut your odds of being audited by more than 80 percent just by choosing a different legal structure for your business, which happens to be the topic of Part 3 of this series.

Putting Tax Penalties in Perspective

So, what if you do get audited. What then? Well, if you properly documented your legitimate deductions, you have little to fear. In fact, 35 percent of audits result in refunds or no change either way.

And what if you lose? You will get what the IRS calls a “deficiency notice” — a bill for unpaid taxes plus interest from the time the taxes should have been paid. If you disagree with the auditor, you can appeal the deficiency notice to the IRS. If you don’t like the result you get there, you can appeal to the U.S. Tax Court. There’s even a “small claims” division for disputes under $50,000.

Are you worried about getting in real trouble, as in criminal prosecution? Don’t be. For fiscal year 2019, the IRS initiated only 2,797 criminal investigations. That’s an almost unimaginably tiny fraction of the 240 million returns they collect in a year. Out of those investigations, they achieved 1,735 convictions (IRS investigators don’t actually prosecute; they turn that job over to the Department of Justice.) Ninety one percent (or 1,583) of those prosecutions resulted in convictions leading to sentencing (the Feds don’t take you to court unless they’re pretty sure they can win).

In the end, the average U.S. small business owner really has nothing to fear from the IRS Criminal Investigations unit. As far as most of us are concerned, the IRS is just the government’s collection agency, nothing scarier. You’ve got to do something pretty outrageous to be the target of one of those 2,797 investigations.

Make Your Case

You can avoid accuracy-related penalties if you have a “reasonable” basis for taking a tax position on your return. A tax position is a reason why you acted as you did regarding something related to your taxes. For example, the reason why you decided not to file a return, the reason you believe certain income you received is tax-exempt, or the reason you chose to shift income from one jurisdiction to another.

Generally, a tax position has more than one chance in three of being accepted by the IRS. You can work with your tax planning firm to file Form 8275 or 8275-R to disclose positions at the time you file your tax return, but the general consensus among tax experts is against filing them. Why volunteer information that can attract unwanted attention? That would be like calling in an airstrike on your own position.

Instead, note your position when you’re completing your tax return, so if you are audited, you can state your position on issues that may be in a gray area.

Document Your Income, Deductions, and Credits

The best defense against an audit is detailed documentation of all income and expenses. We recommend using accounting software for both your business and personal finances, assigning every penny coming in or going out to an income or expense category, and being sure you have documentation for every item in every category that impacts your taxes, including the following:

  • Income: W-2s, 1099s, and income not reported on W-2s or 1099s. If you are audited, you might have to provide documentation on every single deposit that made its way into your bank accounts. Audit-proof yourself by properly recording all deposits in your accounting software or personal ledgers.
  • Deductible expenses: Receipts, invoices, check registers (hand-written or electronic), and credit card statements for all expenses that may be deductible, including:
    • Business/professional expenses
    • Mortgage interest
    • Property taxes
    • State and local taxes
    • Health insurance premiums
    • Health Savings Account (HSA) or Flexible Spending Account (FSA) contributions
    • Medical expenses
    • Childcare expenses
    • Education expenses
    • Costs of any energy-saving home improvements
    • Charitable donations
    • Vehicle records for business use of a vehicle you own
    • Home office expenses

Pro Tip: Assuming you use accounting software to categorize every income and expense item, you can generate reports that provide you with a complete checklist of the documentation needed for each category of income and expense. This will help ensure that you have all the documentation needed to prepare your taxes and to audit-proof your return. You can then move confidently forward, claiming every deduction and credit for which you qualify, knowing that you can back up each one with documented proof.

Take Every Advantage You Can Get

Here at Stees, Walker & Company, LLP we recommend that you take a strong position to claiming deductions and credits. Don’t fear that the IRS will bully you into paying more than your fair share in taxes. For further guidance on what is allowed, please read “Understanding Small-Business Tax Deductions,” which is available here on the Stees, Walker blog.

As a small-business owner, you already have one of the best legal tax shelters available — a business. We can show you how to leverage the power of your business to reduce your taxable income. The first step is to choose a tax-friendly legal structure for your business, which is the topic of Part 3 in this series — “Selecting a Business Entity.”

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Disclaimer: The information in this blog post about audit-proofing your business tax returns, is provided for general informational purposes only and may not reflect current financial thinking or practices. No information contained in this post should be construed as financial advice from the staff at Stees, Walker & Company, LLP, nor is this the information contained in this post intended to be a substitute for financial counsel on any subject matter or intended to take the place of hiring a Certified Public Accountant in your jurisdiction. No reader of this post should act or refrain from acting on the basis of any information included in, or accessible through, this post without seeking the appropriate financial planning advice on the particular facts and circumstances at issue from a licensed financial professional in the recipient’s state, country or other appropriate licensing jurisdiction.