Small Businesses and IRS Audits

“Begin with the end in mind,” wrote Stephen F. Covey in his highly influential book, The Seven Habits of Highly Effective People. How would principle apply to small businesses seeking to minimize tax liability while avoiding IRS audits?

For one thing, it’s important to consider how the IRS is likely to view your return. It’s true that only a relatively small percentage of tax returns get audited. But the IRS uses computerized programs seeking to flag certain returns.

The scoring system is known as DIF, for discriminant index function. The higher your score gets, the more likely the chances of a tax audit become.

Much like Google and its algorithm, the IRS does not disclose its exact mathematical formula. But it stands to reason that the ratio of tax deductions to reported income is probably a key factor.

This doesn’t mean you should forego taking deductions you are entitled to. Just be aware that through the DIF score, the IRS monitors how the size of a taxpayer’s deductions compared to income.

Another indicator that can make an IRS audit more likely is audits of other parties with whom you are associated in some way. For example, suppose the IRS is auditing the tax return of a company that made payments to yours. This could lead to an IRS agent looking at your return to verify that the income from these payments was properly reported.

In other words, be aware of the company you keep. In some cases, it can affect your chances of being audited by the IRS.

Source: “Four Ways to Beat Small-Business Tax Audit,” Fox Business, 11-28-12

Our firm handles situations similar to those discussed in this post. To learn more about our practice, please visit our Texas business audits page.