How Do I Avoid an Audit?

How to avoid an IRS Audit

Ah, the age-old question. Perhaps nearly as old as time itself, or at least, as old as the IRS. By the way, Abe Lincoln formed the IRS in the middle of the Civil War – 1862 to be exact.

What better way to knock your opponents into submission than instill a new method to track their profits and tax them accordingly?  Okay, I’ll spare you the diatribe against “the man,” and hone in on why you’re here – to avoid an IRS audit!

Avoiding an audit isn’t an exact science – it involves managing risks

With that being said, I think it’s more important to ask yourself “how prepared am I for an audit?”

Similar to an exam to detect prostate cancer, it’s not until after you go through something that you understand the value of early-preparedness. Hurricanes, flash floods, a wild herd of horses stampeding through your town – some things are best dealt with by simply hoping they don’t happen, right?

Regardless of where you stand on the issue of preparedness and hope, let’s lean into the actionable things for your situation:

Receipts, Industries, and Outliers

1) Keeping track of receipts for business transactions. None of us want to carry around a briefcase of disorganized, coffee-spilled pieces of receipt paper for five years. I promise, there’s a better way. It involves starting with ONE business category and beginning meticulous record-keeping, as best you can.

You can use an app such as TinyScanner or upload your receipts straight into a google drive / dropbox account. Maybe you start by uploading records for your REI, Target, and Costco equipment purchases, which amount to $10,000 a year easily. That’s a great place to start

2) Be aware of industry-specific expense volumes that apply to your business! That’s a mouthful, for sure – what I mean is that the IRS, like all businesses today, relies on big data to make decisions (including who to audit). You’ll want your expense volume to match up nicely with other people in your industry (aka using your NAICS code). If you’re running a preschool and earning roughly $70k per year gross, then it won’t exactly look normal to expense $25,000 on business travel. Whereas if you were a heavy-machinery consultant and engineer, this would be completely fine!

3) File on time – there’s strength in numbers AND don’t be an outlier. If you wait until the third to the last day before your tax deadline extension runs out, that might be a sure-fired way to get spotted by the fancy algorithms running out in Utah. Similarly, although the IRS does technically accept hand-written returns if the writing is completely legible, this is a great way to get put under an additional layer of scrutiny. By all costs, stay with the pack, file with the herd, and blend in! (ever seen that 1984 apple commercial?)

The schedule C is not as much a sandbox as the blank boxes might indicate

There are 27 general categories for expenses on the Schedule C. You won’t want to fill all of these in, though. You’ve got Advertising, Contract Labor, Insurance, Legal & Professional, Office Expenses, Rent & Lease, Supplies, Travel, Meals, and Utilities to name some of the common ones.

Let’s take a look at contract labor and rent & lease specifically, as these are great examples of the additional risk you might unknowingly place on your business.

It’s completely reasonable for an event production company to spend $20,000 per year on contracted labor (freelance contractors) in order to generate $200k+ in revenues, right? Totally right. Hiring humans is expensive, and of course that’s why many companies are outsourcing to robots – but maybe not event production companies. They’ve got aerialists, tight-rope walkers, and fire eaters among those wage-earners.

And surely those artists deserve a living wage.

You must issue a 1099-NEC if any of these performers earns more than $600 over the course of a year.

Of course you could have paid 60 performers $300 each to arrive at your $20,000 of contract labor expenses. How likely is it that you had absolutely zero of your workers earning more than $600 in the year? Not likely – and the IRS knows this. They also see first-hand all 1099 forms issued in the USA.

So if you want to show $20,000 on line 11 for ‘contract labor,’ you had better issue some 1099s. This will show the IRS you are on top of your documentation!

Now let’s talk about rent – another thing that could increase your audit risk.

Rent and lease payments can rack up quickly, and make for an easy deduction

You spend loads of time in your home, doing work on your business – calling contractors, organizing with suppliers, creating content-marketing pieces for your online-presence…

That means when you pay that $1,200 in Venmo to your landlady on a monthly basis, you think a strong portion of that is business-related.

Here’s the reality: The maximum deduction you can take is $1,500 per year if you have a 300-square-foot home office. That’s it. The IRS has a separate form to fill out – form 8829, and you can find it here: []

But what if the spot we’re talking about is REALLY for business? Truly. Maybe you even have a separate living quarters all-together. Either way, it is completely possible to expense your business-related-rent and utilities. Granted there are a couple of technicalities:

Firstly, your lease should be signed by your business entity (unless you are a sole-proprietor).

Secondly, you are legally required to issue your landlady / landlord a 1099-MISC if you will be sending them more than $600 over the course of the year for payment from a business.

This is where, similar to the contract labor section above, you can be fooled and corralled into the audit corner of the IRS databases.

Don’t be Fooled!

If you’re showing over $600 on line 20b for business property rentals, the IRS expects that either you are renting from a wide variety of sources for low-cost (e.g. several storage units from different vendors, massage-room rentals at various studios, other business-focused hourly rentals), OR they expect to see that you’ve issued somebody a 1099-MISC in relation to business rent.

If you do decide that you should be able to expense your rent for business purposes, you’ll want to involve your landlady / landlord / property management team from a hypothetical point of view. Reason-being that it is often written in residential lease agreements that the property will not be used for business-activities.

You cannot just issue them a 1099-MISC and call it a day – this would often be a lease violation. If the manager of the property is ‘very cool,’ they might be completely willing to rewrite the lease to list your business entity and accept a 1099-MISC all so that you can reduce your tax burden (legally). This is no guarantee, though – so check in with them!

For additional reading in regard to audit risk, see this article by Bloomberg.

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