Updated: Dec 3, 2021
Even though you pay your taxes on time each year and keep excellent books, the IRS might decide to audit your return.
The number of audits continues to drop each year, with less than 1% receiving any attention from the government. That’s good news for small business owners unless they are one of the 1 million taxpayers that go through this experience annually.
If you want to reduce your risk of triggering an audit, then these are the red flags that you must avoid when filing a return.
List of the Red Flags the IRS Tries to Find
Most small businesses file their returns through a financial advisor or with tax-reporting software. That means it is easy for the IRS to access the income figures that get reported each year. If there is a discrepancy in this area, then you are almost guaranteed to receive an audit.
Once you’ve addressed that issue, your business will want to focus on these critical points.
There are net losses reported on multiple returns.
If 40% of your returns over the past five years of operations report a net loss, then your risk for an audit will rise. This issue impacts partnerships and sole proprietors most often, but it can apply to any business structure. Make sure that you can back up your income and deductions with documentation, receipts, and logs to avoid issues in this area.
You might also encounter problems with an audit if you are rounding your numbers or using averages on your return. If you know that a net loss is going to happen, then it is a best practice to work with your decimal points for expenses and earnings.
Your business keeps missing the filing deadline.
If you file your tax return after the April deadline consistently, then this pattern can create some unwanted attention. Some business owners wait until the last second to complete their paperwork because they know a bill is waiting for them. It helps to budget for this possible expense as early as January to ensure that your company stays under the radar.
Filing your return late can also cause you to pay penalty fees. If you know that your company will miss the deadline, then request an extension.
The salaries for your shareholders are above average for your industry.
The IRS pays attention to companies that have shareholders who are also high salary earners. Anyone who earns over $200,000 per year has an increased risk of facing an audit, even if they receive a W-2 form from a traditional employer.
If your leadership team earns what they are worth, then you have nothing to worry about with this red flag. When the income seems to be extraordinary, then an audit might be coming your way.
Several business deductions appear on your return.
It is tempting to take every travel expense and purchase as a deduction when you operate a small business. If you take too many on your return, then your risk of an audit increases. The best practice to avoid this red flag is to remain consistent. If the cost is ordinary and necessary for your operations, then it probably qualifies – and you should take it.
If not, then it might be wise to leave it alone. Most expenses are only going to save you a few dollars on your return anyway.
Your business gave a lot of cash to charity.
If you suddenly shift a lot of profits toward a charitable organization, the IRS might become suspicious of your behavior. An audit might happen to determine if you made that decision to avoid paying taxes.
Although an audit for this reason alone is rare, it might cause someone to review your returns more closely than they would otherwise. That’s why any charitable giving should be consistent with what you did in the previous year.
Your business vehicle deduction seems high for your industry.
If you claim a 100% business use for a vehicle of the owner of a small business, then the IRS will pay more attention to your return. You must be prepared to show that every trip made with your car was business-related in the past year. If you travel to meet with clients, conduct research or deliver outgoing mail to the local post office, then those expenses qualify.
When you drive to Starbucks to grab some coffee to get past your 2 pm wall, that’s an expense you probably shouldn’t try to deduct.
You have the choice to use the actual expenses or the standard mileage rate for the business use of a vehicle. Trying to take both will raise a red flag on your return.
Most of your income involves cash transactions.
If you operate a business that involves cash payments, then the IRS sees this as a red flag. It is more challenging to verify figures with this setup than it is with debit or credit cards. Any large transactions that get reported will be a cause for concern, such as the purchase of a new vehicle for your company in cash.
It would help if you tried to pay for any business expenses with a debit or credit card to create a record of the transaction. If you must pay in cash, then save all of your receipts to verify the activity. Then make sure that you complete Form 8300 if you have cash receipts that exceed $10,000 from a single buyer for the year.
There is an outstanding income that didn’t get reported.
The IRS expects you to report any income you make in the United States. That includes anything that you hold in offshore accounts or cash payments. If there is a suspicion that you’re withholding income, even unintentionally, then that is a red flag for an audit.
Small business owners need to avoid co-mingling their personal and professional books whenever possible. That’s the best way to avoid mistakes that could lead to an underreporting of income.
You accept cryptocurrency as a form of payment.
If you use a cryptocurrency like Bitcoin as your primary method of conducting transactions, then the IRS might decide to take a look at all of your figures. Since the blockchain offers transparent information, a complete record of each activity becomes available for review. That means all of your books must be in order if you center your company around this option.
Your deductions focus on your Schedule C filings.
Some experts believe that filing a Schedule C could increase the chances of being audited. That doesn’t mean you cannot take the deductions you’ve earned or only use the standardized figures. You must carefully choose which items to deduct so that you don’t raise any concerns with your report.
When you take a home office deduction, list advertising expenses, or calculate the cost of office supplies, it helps to have a documentation trail that you can use to support your claims.
What Happens If I Get Audited Anyway?
You can get audited even if you do everything right. If you have your paperwork in order, then the process to follow is straightforward. You should contact a trusted tax professional right away if you have any concerns about the matter.
When IRS agents speak with you, try to keep a positive attitude. If you are honest and organized, then the process will go smoothly. Then make sure that you read every tax notice that comes your way, even if you’re tempted to ignore them. Keep all of the documentation that the IRS sends you.
Although no one can audit-proof their return, small businesses can reduce their risks by keeping meticulous records and being honest about their income. If you have any questions about these red flags or tax questions in general, then feel free to reach out at any time with those concerns.