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.
