5 Factors of Audit Risk for Small Businesses

While your risk of being audited is low and likely to stay low according to the IRS commissioner*, it’s still scary to think you may find yourself under the IRS microscope. Can you avoid this? Maybe. Will knowing your risk factors put you more at ease? Hopefully.  Here are 5 factors that impact audit risk for small businesses.

Entity type

Believe it or not, the way in which you organize your business from a legal standpoint impacts your audit risk. Statistics in the 2014 IRS Data Book show that an S corporation or partnership (including a limited liability company filing a partnership return)—regardless of income or other factors—had only a 0.4% chance of being audited in the government’s fiscal year ending September 30, 2014. In contrast, a sole proprietorship with gross receipts between $100,000 and $200,000 had a 2.4% audit risk (or 6 times as great as the other pass-through entities).

Does this mean that sole proprietorships should change their entity form? Not necessarily, because it is less costly from an administrative perspective to operate as such. However, it’s important to recognize that being a sole proprietor places greater need on owners to maintain good books and records and follow tax rules.

Income

The amount of gross receipts (fees, sales receipts, and other earnings before any deductions) impacts the audit risk of sole proprietorships. Here’s what the Data Book shows for the government’s 2014 fiscal year:

Gross receipts	Percentage of returns audited
Under $25,000	1.0
$25,000 to under $100,000	1.9
$100,000 to under $200,000	2.4
$200,000 or more	2.1

Does this mean that if you’re a sole proprietor, you should control your income to minimize audit risk? Of course not. Knowing your audit risk simply puts you on the alert to use good business practices as protection in case of audit.

Location

IRS offices are staffed differently in various locations across the country, enabling some offices to conduct more audits than others. There is no current data on how this impacts your audit risk (in prior years, certain districts such as Manhattan, NY, and Houston, TX were known to have higher audit risks).

Again, should you relocate to a place with little or no IRS coverage? No. Just be prepared to face an audit if you have to by carefully tracking your income and expenses.

Deductions

The type and amount of deductions claimed can flag a return for audit. Because travel and entertainment expenses deducted for business may arguably be more personal in nature, the IRS looks carefully at these write-offs to make certain they are legitimate and that they’ve been adequately substantiated.

Also IRS computers are purported to select returns of businesses that take unusually high deductions relative to their income. (One government agency reported back in 2004 the average expenses for sole proprietorships.) Once selected, an agent may look a little more closely before deciding whether to commence an examination. This may simply be asking for substantiation of deductions claimed on the return (a process that can be done by mail or phone).

Businesses should take every deduction to which they are entitled. However, they must have required documentation (e.g., receipts, logs) for them.

Type of business

Cash businesses are suspected of omitting income because they can; there is little or no paper trail. In fact, cash businesses are said to be a large part of the more than $450 billion tax gap. The tax gap is the spread between what the government thinks it should collect and what it actually collects.

There is an IRS audit guide specifically for cash intensive businesses (e.g., beauty shops, car washes, laundromats, and many other types of small businesses), which instructs agents about what to look for during an audit. Cash businesses should review this guide to learn what they can do to create audit protection, just in case they are selected for examination.

Conclusion

Some people continue to believe that taking a home office deduction is an audit red flag. There are no statistics or other evidence to show this is true. According to the SBA, 52% of all businesses in the U.S. are home-based, so it’s not likely that the IRS is going after every one of them.

The conclusion that these factors lead to is that no one thing triggers an audit; you are at risk under any of these or other factors. The best course of action: Retain all receipts and other tax papers (even if scanned into your smartphone or desktop), conscientiously record income and expenses, and work with a tax professional.