A small business owner has enough to worry about, without the stress of an IRS audit. Avoiding an audit is simple when he understands how the IRS chooses which business returns to select. Passing that audit is even easier. Let’s start with a look at who’s at the top of the IRS audit hit list.

The hobby audit

The businesses that are most likely to be audited by the IRS are people trying to make a living doing what others do for fun. This includes people who work with horses or dogs, paint pictures, write books, gamble, play music, fish, or sell handmade items.

If you fail this audit, your deductions will be severely limited. If you work in one of these industries, you must document everything you did to generate income and operate a business. Operating in a business manner includes regular bookkeeping, writing a business plan, actively seeking sales or work, tracking sales efforts, and making adjustments to increase profits.

The repeated loss audit

Any small business that does not show profit for three years in a row can receive a second review by the IRS; show a loss over a longer period and your business performance could be audited. Beating this one requires you to show that you have a profit mindset.

Showing that you have a profit mindset is also done by showing that you operate like a business. Accounting records, a copy of your business plan, a list of activities scheduled to increase sales, and proof that you made changes to increase profits will be needed to pass this audit. Taking business and marketing classes also shows that you are trying to increase profits.

The scandalous audit of deductions

Inflated mileage deductions, RVs, vacations written off as business trips, a TV for the home office, and other outrageous purchases attract IRS audits like a porch light attracts bugs. Buying an RV to take you and your pet to dog shows, ruling out a trip to Europe because you did some business too, fake mileage and home electronics will not pass this audit.

A good rule of thumb is…if you don’t want to see your neighbor use their tax-funded welfare check to buy it, then the IRS and honest businessmen don’t want to see you buy it with false deductions, causing them to pay higher taxes while you avoid paying yours. Honesty and proper record keeping is the key to avoiding and passing this audit.

Document correspondence audit

When the IRS adds up all 1099s received in your name and/or tax identification number, if that total is less than the business income reported on your tax return, you will receive a letter.

Most businesses actually make more income than the total of all 1099s received because small jobs don’t necessarily get 1099s issued. You should report all income received, not just all income reported on a 1099. Falsifying your income will cause this audit to fail, even if your reported income matches the total of all 1099s.

Depositing all business income into a bank account reserved exclusively for business funds is the best way to document your income. Then, at the end of the tax year, simply compare the total income deposited to the total of all 1099s received. If your 1099 total is more than your deposits, you’ll need to find out who misreported your income and request a reissued 1099 before you file your taxes. Otherwise, the IRS will assume that you received that money. The proper amount to report is your total income.

The random audit

This audit is just bad luck. Someone had to be audited and his statement made it to the desk. And when he did, an IRS employee spotted a “potential lie” on his return. It could be a larger travel deduction than industry standards, smaller total tips than others in your profession, a new computer purchased in December, or mileage figures that don’t seem right. The test trumps this audit.

To summarize, proper record keeping is the answer at all times. If you keep all your receipts, document all your mileage, use a business bank account, operate as a business, and hire a tax professional to attend the audit for you, you should pass any audit that comes your way.