No one wants to be audited by the IRS, especially small business owners.
Sometimes an audit is conducted at random and can’t be avoided, but most times, there are steps you can take to avoid landing under the auditor’s microscope. In today’s post, I’ll clue you in on why small businesses get audited so you can do as much as possible to avoid it.
Understandably, you may have missed the IRS’ announcement in late 2020 that told us they would begin increasing tax audits for small businesses by 50% in 2021. Luckily, those audits are often triggered by mistakes that are totally avoidable. Here are the 10 most common red flags for why small businesses get audited:
Red Flag #1: S-Corporation Shareholder-Employees Not Earning Enough
If you have an S-Corp, remember that you must pay yourself reasonable compensation. This also applies to any other shareholders that work as employees for your company. The IRS knows that some business owners try to avoid employment taxes by paying themselves as little as possible, but that is not going to fly, and it’s one of the biggest reasons why small businesses get audited.
Red Flag #2: Deducting Too Much
First of all, you should take as many tax deductions as you legitimately can for your business. If you are entitled to a deduction, do not hesitate to take it. However, make sure that the deductions you take are in line with the type of business you have and that you’re not “stretching the truth” when it comes to these deductions.
For example, if you are taking the home office deduction, make sure you’re basing your calculations off the square footage of your office space that is used solely for business purposes. In other words, if you like to move around in your house and work from your dining room, bedroom, or living room on any given day, you cannot use all of those rooms’ square footage in your calculations for your home office deduction.
The auto expense deduction is another one that can get you into hot water if you aren’t accurate with your calculations. Many small business owners don’t use their vehicle solely for their business, so claiming every mile or every cent of each repair can draw the IRS’ eye. Also, trying to use both methods for calculating your auto expense deduction–expenses and mileage–is a no-no, so make sure you choose which method works best for you and stick to only using that one.
Other deductions that commonly create issues with the IRS are those for meals, travel expenses, and charitable contributions. Remember that meals and travel expenses should align with what business owners in your type of business are spending on those items. Make sure you have the documents and receipts to show as proof that those expenses were for business purposes. In regards to charitable contributions, the IRS is on the lookout for businesses claiming to have made large charitable contributions in order to avoid paying taxes.
Red Flag #3: Never Making a Profit
It’s understandable that your small business might not turn a profit in the first couple of years. However, if after that initial phase your business is still reporting losses, the IRS might want to take a closer look to make sure you’re running a business and not just practicing a hobby. They will allow you to deduct business expenses for a legitimate business, but they will not allow you to deduct business expenses for a hobby.
Additionally, if you have a sole proprietorship, the IRS may take a harder look at your business if you’re continuously reporting losses. This is why it’s important to keep accurate records and use different banking accounts for your personal banking and business banking.
Red Flag #4: Sloppy Math
This might seem like common sense, but if your numbers are hinky, the IRS is going to want some explanation. For example, if all of the numbers you’re reporting are round numbers or numbers that end in a 0 or 5, that tells them that you’re likely not reporting accurate amounts. If you have several math errors on your returns or are missing forms, that can trigger an audit as well.
Red Flag #5: Too Many Cash Transactions
Unfortunately, no matter if you work in a field where mostly cash transactions are typical, such as a craft vendor or hair stylist, the IRS will look more closely at any business where a significant amount of cash is flowing in the door. The only things you can do to help yourself in this area are to make sure you are keeping detailed books and reporting any cash payments over $10,000 on Form 8300 by the 15th day after the transaction.
Red Flag #6: Sole Proprietors Reporting a High Income
If you file a Schedule C as a sole proprietorship, then the more money you earn, the more likely you are to be audited. The IRS wants to make sure that your business expenses and personal expenses (and taxes) are being reported accurately, so when they see a sole proprietor making well over 6 figures, they may want to inspect those numbers. You can avoid this extra unwanted attention by changing your business entity to an LLC or S-Corporation.
Red Flag #7: Too Many Independent Contractors
A state’s department of revenue is likely to kick off an audit (and then notify the IRS they should do the same) if they find that a business has misclassified its employees as independent contractors rather than employees. Some businesses will do this to avoid paying payroll taxes at the state and federal levels, so make sure you are classifying and paying your workers appropriately in the eyes of the IRS.
Red Flag #8: Not Paying Quarterly Estimated Taxes
If you think you’ll owe more than $1,000 in taxes over the course of the year, then paying quarterly estimated taxes on time is a good way to not draw scrutiny from the IRS.
Red Flag #9: Not Filing On Time
While this might not be a red flag in and of itself, when your business doesn’t file taxes on time, it definitely gives the IRS more time to scrutinize your return. Obviously, you’ll also accrue late fees and penalties if filing late, so it’s better to just get it done before the deadline.
Red Flag #10: Not Following Other Rules
If you fall under investigation for issues with reporting other types of taxes such as state payroll tax or sales tax, or if you’re being investigated for worker’s compensation or unemployment claims or anything similar, those investigations could actually lead to the IRS auditing you as well. While some of these situations may be out of your control, the best way to keep the IRS off your back is to make sure you’re following the letter of the law in all areas of your business.
The vast majority of small business owners will never be audited, but it’s important to understand what you can do to help ensure you won’t be one of those unlucky few. In general, you can stay in control of your business taxes and off the IRS’ radar by consistently doing these things:
- Keep accurate records of all transactions and expenses.
- Pay yourself and your employees reasonable compensation.
- Classify and pay your employees correctly.
- File your taxes on time and make sure your tax forms are thorough and accurate.
- Take all of the tax deductions you can but not more than you’re entitled to take.
- Pay your quarterly estimated taxes.
- Keep your personal finances and business finances separate.
- If you need help with your taxes, contact a professional.