How To Reduce Your Audit Exposure
POSTED ON October 24, 2023
BY Mallory Sage

Do you know how to reduce your audit exposure? Do you know what audit exposure is? Does reading the word “audit” just kind of stress you out? Then keep reading to figure out how to minimize your likelihood of being audited.

The Basics on Audit and Audit Exposure

A tax audit is basically a deep-dive into your tax return where the IRS makes sure that what was reported on your return was accurate. There are a lot of things that may flag your business for an audit, which is why it’s important for you to keep good records. It’s your accountant’s job to do everything they can to accurately represent your business and expenses, while also maximizing your yearly savings.

Which leads us to audit exposure. Audit exposure is your risk of being audited – and no one wants to be audited. Your goal should always be to REDUCE your audit exposure. A good accountant will always weigh your audit exposure and tax savings while preparing your return.

Who Is Most At-Risk For Audit?

Schedule C’s are one of the most audited schedules by the IRS. This is the schedule a sole-proprietor uses to report their income and expenses for the year. Due to the added complexity of this form over a W-2 employee, it has more room for errors or fraud, so the IRS reviews them more frequently. They are mainly looking for unreported income and exaggerated expenses.

Additionally, in September of 2023, the IRS announced a new task force focused specifically on compliance for pass-through entities. Pass-through entities are entities don’t pay a corporate income tax – instead, it’s “passed through” to the individual tax return. This includes S-Corps and partnerships. With new scrutiny comes an even higher risk of audit, especially for these groups.

What Do You Need In Case of an Audit?

There are two very basic things that you need to be able to prove in case of an audit of your expenses.

  1. You paid for something. This is why it’s incredibly important to keep track of invoices and purchases for your business. If there’s something you would like to include in your return, you should have the proof that you paid for that item or service. For example, when you buy a computer, be sure to save the receipt, bank statement, or credit card statement to show that you actually paid for it. This way you have proof that it wasn’t a fabricated expense.
  2. It was a legitimate business expense that was normal and ordinary. Not every meal is a business expense. If you’re claiming something as a business expense, make sure that it’s a legitimate expense that was relevant to your business, industry, or client. A legitimate expense is an expense that you can show has a legitimate business purpose and is not extravagant. This means it must be normal and ordinary in both nature and amount.

There are different rules regarding what you need to prove if the IRS is questioning your income rather than your expenses. For income audits, the IRS wants to see your invoices in numerical order with no invoices missing. They may also add up all deposits made to your bank account and compare those to what you reportedly made. This is why it’s important to make sure you’ve categorized ALL of your deposits – not just deposits you think you’ll need to include in your return.

Tips to Reduce Audit Exposure

Break Things Into Smaller Categories

When you’re calculating your spending, don’t break things into huge categories. Whenever possible, divide expenses across subcategories. For example, don’t classify everything as “travel.” Instead, spread travel expenses across multiple categories like flights, car rentals, lodging, and rideshare expenses. You never want to have a huge amount of spending in any one category.

Large amounts in a category that exceed the expected amount will immediately flag the AI reading your return. The key expense categories at risk for audit are meals, travel, entertainment, and auto. These are the categories that can be highly abused, which is why they are under the most scrutiny. Even though these are often legit expenses, breaking them down helps avoid audit.

Consider Your Entity Type

When it comes to audit exposure, entity type matters! As mentioned, sole-proprietors are the most at-risk for audit. If you have a sole-prop, becoming an S-Corp could significantly reduce your audit exposure. However, making an S-election isn’t a decision you should make purely based on audit exposure. There is an additional cost associated with becoming an S-Corp and that should also be a factor you consider before making an S-election. If your net income as a sole-prop is $60K or more, you have reached the “break even” point where the extra savings as an S-Corp outweigh the administrative cost. Changing entities is a nuanced decision that you should discuss with your accountant before committing.

Keep Good Records

The most important thing in audit exposure reduction is keeping good records. Good records may not prevent you from being audited, but it ensures that if you ARE audited, you’re prepared. Keeping good records makes proving that you a) paid for something and b) that it was a legit business expense much simpler.

Finding the Balance

Saving your money will always be the number one goal – but there is incredible value to presentation and exposure reduction. You’re paying your accountant to do both!