The word “audit” makes many business owners shudder. No one likes the idea of the IRS digging into their books looking for mistakes and finding ways to increase their tax bill. But, historically, the rate of audits for small businesses has been so low that audits were almost unheard of. That’s about to change for 2021.
Where We Came From
With audit rates at 0.01% for S corporations as of 2018 and much, much lower for partnerships, many passthrough entities just weren’t worried. In fact, some tax “professionals” have even offered questionable advice with the excuse “There’s almost no chance you’ll be audited anyway.”
Why such low audit rates? Pass-through entities are often small and can be very complicated in terms of structure. Unlike a C corporation – which is taxed as a separate entity – pass-throughs are taxed at a personal level for each owner or shareholder. A single S corp can have as many as 75 owners and LLCs can be owned by an unlimited number of people, making an audit a very complex task with little payoff. The IRS has always focused its efforts on bigger fish.
Where We’re Going
Beginning in 2021, the IRS will be increasing its low audit rates for pass-throughs by a full 50%, according to statements made at an AICPA event. Although rates are still comparatively low, this is a huge increase.
We can only speculate that the IRS may anticipate more tax errors with the complexity of COVID relief options like PPP and EIDL. They may also be concerned about fraud in these programs and want to confirm more business details than was previously necessary. It could even be that the IRS is simply feeling the pressure to collect more taxes and they need to focus more on businesses of all sizes. In any case, they’re increasing their number of auditors in order to accommodate the additional reviews.
How Are Audits Triggered?
If you’ve never been through an audit, you may wonder what would cause you to fall into that growing percentage of audit targets. Don’t worry, it’s not random. The IRS has a very small number of auditors and can only manually review cases that are likely to have problems.
The IRS uses a computerized system to score each company or taxpayer. This system assigns scores based on certain “red flags” that indicate a higher chance of errors or omitted information. An example of this would be certain very high deductions when compared to your total revenue. The higher your score, the more likely you’ll be selected for an audit.
What That Means For Your Business
The growing risk of audit can serve as a reminder of the importance of good bookkeeping. At Pooley Accounting, we don’t do taxes. But we do take care of our clients’ books and that’s key to staying out of IRS trouble. Timely, accurate bookkeeping means you’ve got everything in order to support your claims in an audit and avoid it in the first place by not sending up those red flags.
But remember, accurate books and accounting aren’t just about avoiding an audit. While the risk of an audit just went up, there is a 100% chance you’ll need accurate books to make smart business decisions and that it will cost you money each and every month if you don’t have good data to work with.
So make sure you keep your books in tip-top shape, keep supporting documents for those deductions, and steer clear of any tax preparers who use low audit risk as a guiding principle. Please call our office at (314)-260-7808 to learn more about the services we offer.