While tax audits of therapy practices are rare, it’s wise to do everything you can to avoid one.
An IRS audit can be costly and time-consuming. And in the event the IRS finds you reported your income and expenses inaccurately, it could result in hefty penalties.
This article covers seven steps you can take to reduce the likelihood the IRS will audit your therapy practice. But first, what is an IRS audit? And what happens when you’re audited?
What is an IRS tax audit?
When the IRS audits your business, they go through your financial records to make sure that everything you’ve reported on your tax return is true.
If one of your tax returns is going to be audited, the IRS will typically do it within two years of the year you filed. In some cases, they may stretch it up to three years.
If the IRS finds serious errors on your tax return—and suspects fraud—they may go back up to six years.
Typically, a business is elected for auditing automatically by a computer algorithm. The file is then passed to a human being for further review.
The IRS doesn’t release data on precisely what features of a particular tax return will trigger an audit. Some audits are completely random.
However, there are a few red flags the IRS algorithm watches out for:
- If there’s a major discrepancy between two sequential tax years. For instance, if your income increases $90,000 from one year to the next, with nothing else on your tax return changing.
- If you itemize expenses that are uncommon for similar businesses in similar financial situations.
- If someone you regularly do business with has been audited.
What happens during an IRS audit?
If your therapy practice is audited, you’ll get a letter in the mail from the IRS notifying you of the fact.
Once the audit begins, the IRS will send you requests for financial information. About 75% of personal tax audits are carried out entirely through mail.
You may need to meet with an IRS representative in person to answer questions about your business. You’ll receive plenty of correspondence from the IRS before this meeting takes place.
It is extremely rare for an IRS agent to show up at your house or your office unannounced—so much so that, if someone does show up claiming to be the IRS, it’s likely a scam.
How likely is your therapy practice to be audited?
In 2021, the IRS announced that they would increase the number of audits by 50%, with a focus on small businesses.
Don’t let that send a shiver down your spine, though. Even with the increase, audits of small businesses are extremely rare.
For instance, in 2018, the IRS received four million tax returns from business partnerships—and audited just 140 of them. The same year, nearly five million S corporations filed tax returns, and just 397 were audited.
It’s very unlikely you’ll be audited. But there are steps you can take to push that “extremely rare” down as close as possible to “never.”
7 ways to avoid an IRS audit of your therapy practice
IRS audit rates have been steadily declining over the past ten years, making your probability of being audited relatively low. Despite this, receiving a letter from the IRS is still scary.
Being audited can be a very stressful experience that impacts your whole life. Certain errors or omissions on your tax documents, when spotted, almost guarantee an investigation from the IRS or your state taxing authority.
While it is impossible to reduce your chance of being audited to 0%—there are some tried-and-true lessons you can learn to reduce your likelihood of being audited.
1. Avoid “low hanging fruit” errors
Double check your math! You can easily draw unwanted IRS attention to your tax return by making math errors.
Miss a line item, forget to carry the one, and suddenly, in the eyes of the IRS, you become an object of suspicion.
Also, if your revenue is being reported on other tax forms—1099s, for instance—and it doesn’t match what you report on your business tax return, it raises red flags for the IRS.
Taking the time to ensure all the numbers add up, and that you haven’t made any mistakes—even minor ones—could save you major headaches in the future.
Similar to recurring numbers on your tax return, round numbers can draw the attention of the IRS.
If you save every receipt for office supplies over the course of a year, there’s a chance your total will come to $344.15, or maybe $352.90. But the odds of it coming out to exactly $350 are very low.
Round numbers scream inaccurate recordkeeping. Be as specific as possible.
And, while it may seem obvious, try to avoid typos.
2. Document everything
It is important that you maintain documentation and record of anything you report to the IRS on your tax returns.
While you don’t need to prepare intricate spreadsheets or schedules, you should absolutely take notes and document information sources, all of which should be readily available to be produced in the event the IRS comes calling.
In the past, the IRS has focused on business expenses that are out of the ordinary. In particular, if new expenses suddenly appear on your tax return from one year to the next, or a particular expense increases dramatically, the IRS may take notice.
There are perfectly legitimate reasons for your marketing budget to grow 400% in a year, or for your home office deduction to double. But the IRS wants to know why.
You have the option of including extra supporting documents when you file itemized deductions, and if any of your expenses are out of the ordinary, it’s wise to take advantage of it.
The extra info won’t matter to a computer algorithm. But if your file is flagged and it ends up in review with a human, the extra information justifying your expenses could save you from an audit.
Keep a separate file of audit correspondence containing copies of all documents provided to tax authorities.
Prepare supporting documentation so that tax returns will be audit-ready at filing time and develop a records-retention policy that meets the requirements of tax authorities.
3. Have a system in place
You must develop and establish clear and consistent (and, eventually, written) procedures and policies for how you plan on handling your finances.
4. Make sure your 1099s match
1099s that don’t have matching taxpayer identification numbers are “low-hanging fruit” for the IRS.
Make sure any 1099s you receive have your correct Social Security Number (SSN) or Employer Identification Number (EIN), depending on whether you are a sole proprietorship or an S corporation (or any other entity other than a sole prop), respectively.
If this is an issue for some reason (for example, you created multiple entities each with different EINs), make sure your tax preparer addresses the discrepancy when filing your return.
6. Stay on top of payroll
The IRS is serious about payroll remittances. If you fall behind on remitting taxes from a employees’ wages, or forget to file payroll reports, it will draw unwanted attention to your therapy practice, and could eventually lead to an audit.
This is important even if your business has just one employee: you. When your business is an S corporation, you typically pay yourself as an employee.
But just because you’re paying yourself doesn’t mean payroll reporting and remittances are any less important. Staying on top of these tasks is a key part of keeping in the good graces of the IRS.
7. Build a good history of compliance
The IRS has a complete history of its interactions with you. That includes every time you filed your taxes late, made errors on your returns, were late paying, failed to respond to official correspondence, and so on.
They also have a history of every time you were compliant—filing and paying accurately and on time, responding promptly to correspondence, and so on.
One of the best things you can do to avoid the danger of an audit is build a history of compliance with the IRS.
A couple tips for building a good history of compliance:
- If you can’t afford to pay your taxes, don’t just ignore them. Instead, get in touch with the IRS to set up a payment plan. This shows you’re determined to be as compliant as possible. It also saves them the trouble of constantly chasing you down for money.
- File your taxes on time, and only apply for a deadline extension when you need it.
If your file shows that you’re on top of your duties as a business owner, and you don’t create extra hassle for the IRS, it reflects well on your business—and could one day save you from an audit.
Accurate, timely filing is a huge benefit to your business—not just when it comes to avoiding trouble with the IRS. Get help from our complete tax season guide for therapists.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult their own attorney, business advisor, or tax advisor with respect to matters referenced in this post.
Bryce Warnes is a West Coast writer specializing in small business finances.