Small Businesses Need to Be Aware of These Red Flags That Can Trigger a Tax Audit

by | Accounting News, IRS, News, Tax

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.

Small Business Owners Should Avoid These Common Tax Audit Triggers

Small Business Owners Should Avoid These Common Tax Audit Triggers

by | Accounting News, Audit and Accounting, Bookkeeping, IRS, News, Tax, Tax Planning

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.