In general, the likelihood of an IRS tax audit for a small business is slim, but there are various factors that can greatly increase the chances of being targeted. The IRS checks for a range of red flags to pinpoint businesses that are more likely to have discrepancies in their taxes. Read on for seven triggers that could raise your odds of an IRS audit in the future.
Multiple Net Losses
If you report net losses in more than two out of five years of operation, your chances of an audit increase. After all, the purpose of a business is to generate income. Consistent loss of income is a red flag for the IRS. Sole proprietorships are even more at risk than other small businesses due to the commingling of personal and business funds that tend to occur in these setups. The IRS may want to investigate whether your sole proprietorship is actually a business or a hobby, as business expenses are deductible while hobby expenses are not. Be sure to keep detailed records for any deductions you are legitimately entitled to.
Filing Payroll Taxes Late
If you’re aiming to fly under the IRS’ radar, regularly missing filing deadlines is not the way to do it. Aside from penalty fees, late filing can lead to scrutiny that timely filing wouldn’t invite. It’s in your best interest to get ahead of the game in order to avoid dealing with IRS headaches in the future.
Low Shareholder-Employee Salaries
It’s a common move for small business owners to structure their business as an S-Corp instead of an LLC in order to avoid the 15.3% self-employment tax. S-Corp owners must offer their shareholder employees “reasonable” compensation, which is reported as wages on a W-2. The IRS specifically keeps an eye out for S-Corps with extremely low salaries paid to shareholder employees. Double check that all shareholder-employee salaries are within the average pay range according to position, company size, industry, and profitability. It is typically the individual tax return of a shareholder-employee that flags the audit, which then generates an investigation of the company.
Excessive Deductions
Though sole proprietors run a greater risk of scrutiny from the IRS, all small-business owners should be mindful of whether every meal and travel expense truly qualify as a business deduction. According to the IRS, this means the expense is “ordinary and necessary”. Be sure to review year-over-year deductions to remain consistent.
Business Use of a Vehicle
When deducting vehicle use as a business expense, choose between the actual vehicle expense (use the appropriate calculation for this) and the IRS standard mileage rate. Choosing both will alert the IRS. If your vehicle is used solely for business purposes, you may be able to claim a deduction for the depreciation on the vehicle. However, you’ll need evidence in the form of mileage logs that record the dates and purpose of every trip you made throughout the previous year.
Cash Transactions
It is difficult to track and verify cash business deals, thus large cash transactions, such as business equipment or investment property, tend to send a red flag to the IRS. It’s best to use a credit or debit card for these transactions, but if you choose to use cash, be sure to record your transaction meticulously to create your own paper trail. You will also need to file IRS Form 8300 to report any cash payments exceeding $10,000.
Calculation Errors
Make no mistake: the IRS checks your math. When small businesses do their own taxes, it might be easier to round numbers or use averages, but this throws off the math. Be sure to work in decimal points when you report earnings and expenses. Even small blunders, such as erroneous totals for expenses, missing 1099s, or transposed numbers can attract unwarranted attention from the IRS.
The IRS uses a computer program called the Discriminant Function System (DIF) to analyze tax returns and red flag them if they deviate from statistical averages. When a return draws a high DIF score, an agent evaluates it and decides if an audit is necessary. Your business should always be prepared for an audit, and that includes avoid these audit triggers when filing your small business taxes.
Higher Than Average Income
If you report a high amount of income, this may draw red flags for the IRS. Approximately 50% of the returns audited belong to taxpayers earning more than one million dollars per year. For taxpayers who earn more than $5 million, their odds of being audited more than doubles those of taxpayers who earn less.
Underreporting Cash Transactions
Don’t make the mistake of thinking that the IRS has no way to trace cash transactions. Credit card processors submit 1099-K forms to the IRS, which include a report of the total credit card transactions your business processed for the year. The IRS then applies these figures to an undisclosed formula in order to calculate the amount a business should have generated in cash sales. Therefore, if your reported cash sales reflect a lower figure than their formula detects, your business could be at risk for an audit. It’s a smart idea to keep detailed records of both cash and credit card transactions so you can support your claims should your business be audited.
Taking Too Many Deductions
Deductions are important to a small business owner, but claiming too many can raise red flags. Higher than average meal expenses and claiming your car as 100% business can set off alarm bells for the IRS and trigger and audit.
The IRS states that a legitimate business expense must be both ordinary and necessary to qualify as a deduction.
Ordinary expenses = common and accepted in your trade or business
Necessary expenses = helpful and appropriate for your trade or business. Note that an expense does not need to be indispensable to qualify as necessary.
Claiming Consistent Business Losses
Given the primary purpose of a business is to generate money, reporting losses year after year can lead the IRS to question the legitimacy of your business. If your business gets audited and you claimed losses, be prepared with documentation to demonstrate your business’ earnings and expenses throughout the year.
Be Prepared for an Audit
Your business may never need to go through an audit process, but you should manage your business always knowing that it’s possible. Keep precise records, make sure the numbers on your tax return are accurate and honest, report all income, and take suitable deductions. Lastly, consult with an accountant to be sure the totality of your revenue, expenses, and documents are free of missteps or miscalculations.
On Aug. 28, 2020, as part of COVID-19 relief, President Trump issued a presidential memorandum allowing employers to suspend withholding and paying to the IRS eligible employees’ Social Security payroll taxes from September 1, 2020 through December 31, 2020. The IRS then issued guidance on the payroll tax deferral in Notice 2020-65, but some questions still remain, and additional guidance in anticipated. Here’s what we know now.
Notice 2020-65 Provides Basic Guidance
For those implementing the program, the Notice provides barebones components of the payroll tax deferral, which applies to the employee portion of Social Security Tax.
For employees earning less than $4,000 in a bi-weekly pay period, employers would defer withholding/depositing employee share of social security tax on wages earned for payroll periods on or after September 1, 2020.
For employees whose wages fluctuate, the deferral is applicable to wages paid in any bi-weekly pay period during the dates specified in which the employee earns less than $4,000, regardless of wages or compensation paid to the employee for any other pay period. Therefore, the employer may defer to collect the tax in a pay period where the employee earns less than $4,000 but be required to collect it for another pay period where the employee earns more than $4,000.
Though Treasury Secretary Mnuchin announced previously that the deferral program would be optional, the Notice does not specifically address whether it is mandatory or optional.
Departing Employees
One main reason that employers may not be eager to offer the benefit to employees is due to the absence of guidance regarding the situation of an employee’s termination or otherwise leaving employment ahead of paying the deferred amount. The employer and employee can come up with an arrangement (i.e. deducting the amount owed from the final paycheck), but should an employer fail to collect from the employee, the IRS could go after the employer.
To Defer or Not to Defer?
Given that the motive behind the tax deferral program is to get more money into the pockets of employees now in order to make ends meet due to reduced wages and/or hours, employers may think it worthwhile to extend this option to their employees. An average worker who completely defers Social Security taxes until December 31, 2020 would save just under $800, or about $60 per week. Employees must keep in mind that it is a temporary relief in the form of a deferral, not a tax forgiveness, though the President’s Executive Order does encourage Treasury to look into possible avenues for forgiveness. At best the tax deferral is an opportunity for workers to funnel those funds into an emergency savings account, ensuring that the savings will be on hand should Treasury fail to put forth a path for forgiveness and the taxes are consequently deducted from paychecks next year.
The U.S. Government has already started sending stimulus payments to Americans from the $2 trillion coronavirus stimulus bill known as the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which was signed into law on March 27, 2020. But there is still some confusion surrounding the details. Here are some things to know about the stimulus payments.
Income Requirements
The stimulus plan outlines that individuals will receive the following: $1,200 for individual tax payers with an adjusted gross income of up to $75,000; $2,400 for married couples filing jointly with an adjusted gross income of up to $150,000, and $112,500 for heads of household. Additionally, families will receive $500 per qualifying child under the age of 17. Dependents over the age of 17 who are claimed under someone else’s tax return will not receive their own payment, which means that most college students won’t qualify to receive a check. If your adjusted gross income (AGI) is more than what’s outlined above, you’ll fall into the “phase out” category—the more your AGI increases, the more the stimulus amount granted decreases, specifically by $5 less for every $100 over the limits noted above. The total phase out amounts based on AGI are: $99,000 for single filers, $198,000 for married couples filing jointly, and $136,500 for heads of household. The AGI will be based on your 2019 tax return, or your 2018 tax return if you haven’t filed 2019 yet.
Disbursing Payments
Stimulus checks will be direct deposited into the bank account listed on your 2019 tax return (or 2018, if you have yet to file for 2019) beginning mid-April. The IRS will send a physical check to your most recent address on file if a bank account is not listed on either tax return. For those whose banking information has changed since then, the IRS is developing a web-based portal where individuals can provide their banking information to the IRS online to ensure that as many people as possible can take advantage of receiving a direct deposit rather than waiting for a check in the mail. This tool is expected to be available around April 17.
You will receive a notice of payment from the Treasury approximately two to three weeks after your payment has been disbursed, which will be sent to your last known address. The notice will include the method by which payment was delivered (direct deposit or check), the address where payment was sent, and a phone number to contact the IRS if, say, your banking information has changed but hasn’t been updated and therefore you did not receive the payment.
Back Taxes
As long as you meet the income guidelines, you should still receive a stimulus payment if you owe back taxes, even federal, state, and student loans. The one exception is for those who owe child support payments.
Who doesn’t Qualify?
In addition to high wage earners and college students, other individuals may be left out of receiving a stimulus check: senior citizens and disabled people who are claimed as dependents by someone else; non-resident immigrants, temporary workers, and immigrants who are in the country illegally (immigrants with green cards, H-1B, and H-2A work visas qualify to receive payment); unemployed high wage earners: those who earned more than $99,000 last year but are now unemployed will be eligible for a rebate on their 2020 tax returns if they earn below the phase-out limits this year; Too, parents of babies born in 2020 won’t receive their $500 payment for that child until next year.
Low Income Earners
Individuals who make less than $12,000 a year are not required to file taxes. If you fall into this category and haven’t filed taxes in the last two years, you are still eligible to receive a check, but there’s an extra step involved. First, if you receive social security benefits, you will automatically receive a stimulus check. But for the estimated 10 million Americans who fall into the “low income” wage earning bracket, don’t receive social security benefits, and haven’t filed taxes for the last two years, the IRS has set up a web portal that will allow you to register for a stimulus check. Visit IRS.gov and look for “Non-Filers: Enter Payment Info Here”. The IRS has also partnered with TurboTax to set up a web page where individuals can answer a few questions and then choose to receive their payment via paper check or direct deposit.
On March 27 the CARES Act was signed into law in response to the COVID-19 pandemic. Below is an overview of the types of assistance available to small businesses in an effort to lessen some of the economic impact.
Paycheck Protection Program (PPP) Loan
This is a $350 billion loan program that will provide loans to small businesses for 2.5 times the average monthly payroll based on payroll reports from the previous year, with a cap of $10 million.
The interest rate for the Payment Protection Plan is 1%, and loan payments for any non-forgivable parts will be deferred for six months. The loan can become forgivable if funds are used for approved expenses: payroll costs, including continuation of health care benefits during periods of paid sick, medical, or family leave; insurance premiums; employee salaries and commissions; payments of interest on any mortgage obligation, rent, and utilities; and interest on any other debt obligation incurred before February 15, 2020. No more than 25% of the loan forgiveness can be related to non-payroll costs, and the amount of the loan available for forgiveness will be reduced if full-time employee count, salaries, or wages decrease.
Businesses and charitable nonprofits with fewer than 500 employees, self-employed individuals, sole proprietors, and independent contractors are eligible. There may be some exception to larger restaurant and hospitality businesses who have less than 500 employees per location.
Emergency Economic Injury Grants
Small businesses, private nonprofits, sole proprietors, and independent contractors who were in operation as of January 31, 2020 are also eligible for $10,000 of SBA economic injury disaster loans (EIDLs) without a repayment requirement. These loans can be used to pay for expenses such as payroll, paid sick leave to employees, production costs, as well as business debts, rent, and mortgage payments. However, using these funds to refinance pre-existing debt or to pay dividends in not permitted. The deadline to apply for an EIDL is December 16, 2020 for most states.
Debt Relief for SBA Borrowers
Included in the stimulus package is $17 billion for immediate relief to small businesses through standard SBA 7(a), 504, or microloans, which covers loan payments for existing SBA borrowers for six months. This includes principal, interest, and fees. This relief is also offered to new borrowers who take out an SBA loan within six months after March 27, 2020.
Employee Retention Credit
For employers whose businesses were fully or partially suspended as a result of COVID-19, the CARES Act specifies a refundable payroll tax credit for 50% of wages paid by employers during the pandemic. This also applies to business owners whose gross receipts declined by more than 50% when measured against the same quarter in 2019. Qualified employers with 100 employees or less are entitled to the credit, whether business is open or subject to a shut-down order. However, employers with greater than 100 employees qualify for the credit based on wages paid to employees while business is halted due to COVID 19-related circumstances.
Whether you’re working with a robust tax refund, a work bonus, or an inheritance of some kind, here’s a list of positive moves to make with that windfall.
Evaluate Your Debt
There’s “bad” debt and “good” debt. Good debt is an investment that will grow in value or generate long-term income, such as student loans or home equity loans. Bad debt is anything that quickly loses value, doesn’t generate income, and/or has a high interest rate, such as credit cards and cash advance loans. Whenever you come into extra funds, it’s recommended to pay down or pay off bad debt as a top priority.
Consider Your Emergency Fund
Your rainy-day fund should be stocked with at least three months’ worth of living expenses. If yours isn’t there yet, think about boosting it with your refund. If you are a business owner or your income fluctuates, consider shooting for six months’ worth of living expenses.
Fund Your 401(k)
This is a good time to open or boost contributions to your 401(k) or individual retirement account. The 401(k) contribution limit for 2020 is $19,500 for those under age 50, and taxpayers over age 50 are allowed an additional “catch-up” contribution of $6,500.
Open a Roth IRA
If you’re married filing jointly and have a combined adjusted growth income of less than $196,000, you can contribute up to $6,000 to a Roth IRA. The adjusted growth income cap for single filers is $124,000. This is meant to be a long-term money management move, but if you need to withdraw sooner, you can do so tax-free and penalty-fee, though you may owe taxes and penalties on any earnings (not regular contributions) you withdraw.
Invest in Stocks
Assuming you’ve paid off debt, built up your emergency savings fund to three to six months’ worth of living expenses, and boosted your retirement fund, you could think about consulting a financial professional to build a stock portfolio that aligns with your financial goals and personal risk tolerance. Or, if you’re stock market savvy, you can open a brokerage account on your own and start investing in a stock you believe has the potential for growth.
Additional money moves you could make with your refund (again, assuming debt, emergency savings, and retirement funds are taken care of) include making home improvements; opening up a savings account for something big, like saving for a down payment on a house; or donating to charity.
