As a dedicated entrepreneur, you’re focused on growing your dream, but lurking in the shadows are potential pitfalls that could disrupt your hard work. 

Audits might seem intimidating and complex, but they don’t have to send shivers down your spine! With doola by your side, you can turn this challenge into an opportunity for more robust financial practices. 

From automating financial record-keeping to embracing proven bookkeeping tips, we’ll help you create a robust safety net against any audit-related woes. 

In our comprehensive 10-step guide, we’ll equip you with foolproof strategies explicitly designed for small business audits like yours. 

Say goodbye to sleepless nights worrying about compliance issues, and hello to confidence as we embark on this journey together! 

Ready? Let’s get started on audit-proofing your business today!

What Is an Audit?

Once you learn what an audit is, it becomes less horrifying and more inconvenient. It was derived from the word “Audire”, which means “to hear.” And that’s what exactly happens, more or less—a “hearing-out” of your business accounts by the Internal Revenue Service (IRS). 

The IRS will review your business account in its entirety, which means reviewing your financial statements and making sure they match up with your bookkeeping.

It is a thorough examination and verification of a company’s financial records, operations, and processes to ensure accuracy and compliance with laws and regulations and detect any potential fraud or error. 

Usually, they want to make sure that you are operating ethically and within the legal boundaries. For example, you are not reporting less income than you really earned or over-reporting deductible expenses. 

Small businesses may face an audit at any time, regardless of their size or industry. The audit could be triggered by suspected irregularities in accounting records or reporting errors identified during routine checks carried out by regulatory bodies.

The reason could be a random selection through the IRS system or your business transactions or tax returns being flagged due to discrepancies. In some cases, you may get audited by an association if your tax return is connected to another taxpayer who is getting audited.

What Happens When You Get Audited by the IRS?

The thought of an audit can bring up feelings of fear and uncertainty, but the reality is that it is a routine process that all businesses may go through at some point. 

Typically, when you first receive notice of an audit, it will include details about what items on your tax return are being examined and which records need to be provided for review. 

If no discrepancies are found after reviewing all documents during the audit process, the audit concludes without any additional changes or adjustments to your return. 

However, if there are any discrepancies found, the auditor will inform you of the issues and give you opportunities to explain or provide additional documentation to support your claims.

The three possible scenarios are:

1. The IRS does not find anything suspicious and leaves you alone.

2. If they find out you owe them money, you must sign an official document confirming the amount you owe. Then, you pay up.

3. If you decide to dispute it, you will need to consult a CPA to support your argument. The IRS will either reduce the amount you owe, make you pay the full amount, or throw out the charges altogether.

What Types of Audits Can You Face?

Various types of audits can be performed on a small business: internal audits, external audits, compliance audits, forensic audits, and tax audits. These audits can be conducted by internal staff, external auditors hired by the company, or tax authorities.

Internal audits are usually carried out by company employees trained in auditing procedures. Their main goal is to evaluate the efficiency and effectiveness of internal controls and identify potential risks or weaknesses in processes.

External audits involve reviewing financial statements prepared by management to determine whether they accurately represent the company’s financial position. This type of audit is typically conducted by certified public accountants (CPAs) who work independently from the business.

Tax audits specifically examine a company’s tax returns for accuracy in reporting income and expenses. These could be carried out either randomly or as part of targeted enforcement programs set by governmental bodies such as the IRS.

A correspondence audit involves responding to written inquiries from the IRS regarding specific issues on your tax return. These requests usually come in the form of letters or notices sent through mail.

This often includes the IRS requesting additional information or documentation related to specific items on your tax return. The majority of correspondence audits focus on simple issues such as missing documents or minor errors in calculations. 

An office audit requires you to visit a local IRS office for a face-to-face meeting with an auditor to discuss your return in detail. This type of audit is often triggered by discrepancies or red flags found during a correspondence audit.

A field audit involves an auditor coming to your place of business to conduct an in-depth examination. This type of audit is typically reserved for cases where significant discrepancies have been found during previous auditing processes.

During a field audit, an IRS agent will thoroughly review your business’s books, accounts, receipts, invoices, and other financial records to determine accuracy and compliance with tax laws. It may also involve interviews with business owners, employees, and suppliers. 

Importance of Audit-Proofing for Small Businesses

The mere thought of being audited can unsettle any business owner, especially home-based entrepreneurs. However, if you are still wondering why audit-proofing is needed, there are several reasons. 

Firstly, audits can be time-consuming and costly, taking away valuable resources from running your business. By having proper documentation and audit-ready records in place, you can minimize the chances of being selected for an audit by showing that you have nothing to hide.

Small businesses are also subject to various taxes, such as income tax, payroll tax, sales tax, and others, depending on their location and industry. If these documents are not kept or if any discrepancies arise during an audit, they could result in hefty fines or penalties.

While there’s no sure method to predict audits, there are some actions that can put you on the IRS radar. So, if you’re doing any of the following, you increase your chances of getting one in the near future:

1. You could be accused of tax evasion if you fail to report income that has already been reported to the IRS on your W-2s or 1099 forms. 

2. Claiming more and suspiciously big deductions than usual. For example, if you try to deduct 100 per cent of your personal car use, you could stand accused of tax fraud.

3. Misclassifying your employees as contractors or vice-versa.

4. Failing to file and issue information returns on time—W-2s, 1099s, etc.

Steps to Audit-Proof Your Small Business

There’s no foolproof way to avoid an audit. But, if you do the following, you can definitely reduce the likelihood you’ll be subjected to one.

1. Account for All of Your Income

If the IRS finds any discrepancies between your reported income and the actual amounts, it will likely invoke further investigation or a correspondence audit. Underpayment of taxes is an obvious red flag for the IRS, which could even lead to strict actions against you.

So, if you have a side hustle—some consulting or freelance work—be sure to report that income, even if you think you can get away with hiding it. However, you may need to fill out additional forms to report all of your income.

The IRS also compare the income and deductions on your return with the information reported by others, such as employers, banks, and businesses. They also use the information on Forms W2, 1098, and 1099 to ensure that everything matches up.

These forms may overwhelm you at first, but once you know where everything goes, it’s easy to get the hang of them. With doola, you get all the tools and resources needed to navigate IRS forms with ease. 

Our comprehensive Tax Package service takes this entirely off your plate to help you stay compliant and confident.

2. Double-Check Your Tax Return

“To err is human” is a famous quote that suggests it’s natural for humans to make mistakes. However, even a tiny, careless error on your tax return can result in a visit from the tax man. 

Whether it is a minor omission like forgetting to add your contractor’s name, a miscalculation of your tax bill, or an error on your return, the IRS is obligated to investigate your case further. 

In that case, hire a dedicated bookkeeper to ensure you have done everything by the book and your returns are penny-perfect. In addition to keeping your books up-to-date, we also file your taxes for you to avoid all fines for non-compliance.

3. Stay Consistent with Your Accounting

When it comes to accounting, you have to choose between cash-based or accrual accounting and stick to it. However, if you switch back and forth between the two methods, the IRS might think you’re trying to hide something. That’s when they will audit you.

So, no matter which accounting method you choose, just be sure to stay consistent. However, the accrual method is more complex and requires more detailed record-keeping. 

Get started with our comprehensive audit-proof bookkeeping solution that helps you overcome the limitations and challenges of using this DIY method of Excel bookkeeping and accounting.

4. Record it Right—Employee or Contractor

When you hire independent contractors, you need specific tax forms that are different from the ones given to full-time employees. The distinction determines which taxes need to be paid, when they are paid, and who pays them.

For example, you need to share a W-9 form with your contractors and file a 1099 form if you have paid at least $600 to contractors during the year. However, full-time employees receive form W-2 to report salary information and taxes withheld from employees. 

Any misrepresentation of information in these forms can lead to an audit from the IRS. So, if there’s any confusion about which form to use and how to fill it, consult with our tax professional or accountant.

5. Maintain Audit-Ready Records

Neglecting to organize your financial records could have unforeseen consequences for your small business audits. For example, it will be much quicker and easier for you to substantiate anything that the IRS decides to question if you have the proof to support your claims.

By keeping accurate books and financial records, you can prove the legitimacy of your reported profit margin and claimed deductions. This will help to show that you’re running a legitimate business and not claiming tax deductions for your personal expenses.

Start categorizing all of your expenses into different groups with doola Bookkeeping, such as office supplies, rent/mortgage payments, employee salaries, utilities, etc. 

This will help you keep track of where your money is going and provide an organized breakdown for tax purposes.

6. Separate Your Personal and Business Expenses

The IRS often scrutinizes business owners for not separating personal and business finances. That means creditors, including the IRS, can go after your personal assets to clear your business debts and other liabilities.

Unless you are operating as a sole proprietorship, we recommend that you set up a separate business entity, like an LLC, to differentiate between your business and personal expenses. This will give you limited liability protection, stopping them from going after your assets like your home.

You can also obtain an EIN to open a business bank account for your business expenses as soon as you can. This will make dealing with a tax audit that much easier. Form your LLC with doola to ensure your business checks out all the boxes on the LLC compliance checklist.

7. Claim Only What You Can Prove

The most common mistakes small business owners make are claiming incorrect expenses, which are often either not appropriately recorded or personal expenses that are not eligible. 

However, maintaining detailed records that include this information will help you accurately claim legitimate expenses and avoid unnecessary scrutiny. These records will serve as proof if the IRS ever audits you.

The first step in claiming deductions and permitted amounts is to maintain a record of all business-related expenses. This includes receipts, invoices, bank statements, credit card statements, utility bills, and any other relevant documents. 

Before claiming any deduction on your tax return, make sure you and your business are eligible for it by the IRS. Consult our qualified tax professional to ensure you are only claiming applicable deductions and permitted amounts for your specific business structure.

8. Review and Update Financial Statements

The first step in getting caught up with the IRS is not having up-to-date financials. Outdated financial statements can lead to many red flags, such as fluctuations in revenue or expenses, unexpected cash flow problems, or inconsistent tax reporting. 

These could be indicators of potential errors or fraudulent activity within your company. However, most businesses wait until the end of the year to update these documents, which can lead to more problems than it solves. 

Keeping these statements updated will allow you to identify any discrepancies or errors early on, giving you enough time to rectify them. 

It’s also crucial that all stakeholders’ and members’ finances comply with state and federal laws since your business may also get audited by association if they get audited by the IRS.

Maintaining your financial statements may seem overwhelming at first, but with the right tools and support from doola, it becomes much more manageable. 

With our audit-proof bookkeeping solution and a team of bookkeepers, you can automate your financial record-keeping and simplify reporting without any hassle.

9. Think Twice Before Reporting Your Losses

The IRS has a soft spot for struggling small businesses and may go easy on you if you are going through a rough patch. However, some business owners abuse it by intentionally showing made-up losses, which can blow up on their faces.

IRS’s perspective is that if you fail to make a profit in three out of the last five years, it is a hobby, not a business. Therefore, you get no tax deductions from hobby-related purchases, investments, or losses. 

Moreover, IRS agents might even come back to retrieve all the benefits you received in previous years based on your business operations. Our advice is to consult a tax professional before claiming any business-related tax deductions and don’t report losses for some peanut amounts.

Get Started with doola Bookkeeping

A tax audit can be a time-consuming and stressful process, which can also result in fines and penalties if your financial records are not up to par. Luckily, doola can help you avoid it all.

With doola bookkeeping, all of your financial transactions are automatically categorized and recorded in compliance with IRS regulations. This eliminates the risk of errors or forgetting to update books, both of which can trigger red flags during an audit. 

If you want a more hands-on approach, you can hire our dedicated bookkeeper to manage your financial transactions. This gives you peace of mind, knowing that all aspects of your finances are being handled professionally by experts.

In addition to bookkeeping, we also ensure that all necessary forms and schedules are filed correctly and on time, preventing any delays or penalties from the IRS. 

Don’t wait until it’s too late – take the necessary steps now to audit-proof your small business with doola.