First thing’s first: Don’t lose sleep over the latest small business boogeyman. Contrary to the fears and rumors among many US small business owners, the IRS is, in fact, not raising an army of auditors that will be coming to get you next tax season.
It’s true that the IRS is hiring; the Inflation Reduction Act that passed in mid-August does indeed call for the hiring of up to 87,000 new agents. But these hires are mostly to keep up with modern tax demands and an increasing US population, and to replace retiring agents (an estimated 50,000 by 2028). Plus, those “agents” aren’t even necessarily auditors. At the end of October, the IRS reported that it has hired 4,000 agents—all of whom are customer service representatives tasked with answering inquiries and (hopefully) unclogging its notoriously impenetrable telephone assistance lines.
In short, no, an audit is not inevitable. However, an audit is always possible, and there’s no better way to invite that possibility than sloppy bookkeeping. So, since the topic is on everyone’s mind anyway, let’s brush up on best practices for tracking those business expenses.
The IRS recommends what is called a “contemporaneous approach,” basically organizing and tracking your expenses as they occur (aka, “contemporaneously”). Here are seven ways to help you ensure you are prepared in case of an audit—or, better yet, to hopefully prevent an audit from occurring.
1. Know What to Track—Then Track it
For a truly airtight expense record, you’ll need a specific tracking strategy for:
Cash flow
Expenses
Charitable giving
Some business owners prefer to develop these strategies and track them all themselves, to save some money at the cost of time. Others prefer to outsource it to a bookkeeper. However you decide to do it, it is an absolute must that you commit to doing it consistently.
Those in the do-it-yourself camp tend to let things slip after a while, often leading to nightmarish tax prep as they scramble to remember and record all their expenses at once—or, worse, they find the IRS knocking on their door.
In our opinion, the savings just aren’t worth the headache.
2. Know What to Keep Together
The only thing worse that forgetting what you spent is forgetting where you stashed away the forms that tell you what you spent. If you want to avoid tearing your office apart in search of a missing receipt, you’ll store all your financial information in one place.This includes past tax records, as businesses are required by law to keep at least three years of tax documentation on hand in case of an audit.
Prefer physical copies? Assign one drawer or folder to the task of storing your expenses. Hate all the paper? Keep digital records instead, either locally or within the cloud. You might also store your expenses within your subscription service app.
3. Know What to Keep Apart
They say you should never mix business with pleasure, and the IRS agrees: Keep your business and personal accounts separate. And by “separate,” we mean “as separate as possible.” Separate credit cards. Separate bank accounts. Maybe even separate banks, if you are especially prone to this habit.
The more your expenses overlap—say your personal vehicle doubles as a work vehicle, or you bring your family along on a business trip and put it all on the company card—the more your expense reports will raise an auditor’s eyebrows.
4. Automate as Much as You Can
Once upon a time, professionals kept all their business receipts in a manila envelope. This is still a good practice (see #2), but nowadays there are many apps and software options that can augment or even replace that envelope. Sync all your accounts, upload photos of receipts, write and deposit checks remotely, and enroll in autopay for recurring bills and invoices. The future is awesome.
Keep in mind, though, that technology is not infallible; it’s wise to review your transactions regularly to make sure your money is being moved where and how it should. An unwatched account is at a greater risk of fraud (see “Unfair Share”).
5. Get Your Deductibles in a Row
This is one of the key areas that triggers disputes, so it’s critical to understand what does and does not qualify as a deductible. According to the IRS, business deductions should be both ordinary and necessary. In other words, any expense that is common for businesses in your industry and is necessary for keeping your business running can be a deductible. Pretty straightforward.
Except not really. The danger is in the expenses that seem deductible, but come with caveats (e.g., home office space, work lunches, capital expenses) or aren’t deductible at all (e.g., commuting costs, insurance, legal fees, business attire). When in doubt, ask your accountant. Aren’t you glad you have one?
6. Keep Your Expenses to Yourself
However much your personal finances can complicate your expense reports, your employees’ finances can complicate them even more. Remember: Only businesses can make business deductions. Employees cannot make business deductions on their personal taxes.
This is a relatively new change, within the past few years, so some people may find the consequences confusing. But the long and short of it is, if an employee incurs a personal expense on behalf of your business, they can only be reimbursed through your business. If your employees are frequently making business purchases, consider giving them a company credit card. It’s less hassle for everyone and makes those purchases more trackable to boot.
7. Record Charity With Clarity
Even if they are given in your business’s name, charitable contributions are not a business expense if you are a sole proprietor reporting your business income on a Schedule C. But they could potentially be an itemized deduction on your personal return.
If the contribution is in exchange for a sponsorship, it can be categorized as advertising or marketing rather than charity.
