Audits by the Internal Revenue Service (IRS) are rare, but there are certain behaviors the IRS tends to keep an eye out for. The reasons for an audit are not always clear, but here are six of the most common IRS red flags for small businesses to avoid.

Small Business IRS Red Flags to Avoid

Common IRS red flags include cash businesses, excessive losses, vehicle deductions, meal deductions and entertainment, home office deduction, and a reasonable salary.

If you file any of the following IRS forms for your small business, you should keep this list of red flags in mind.

  • C-Corporation (Form 1120)
  • S-Corporation (Form 1120S)
  • Partnership (Form 1065)
  • Sole-Proprietor (Schedule C of Form 1040)

1. Cash Businesses

If your business operates strictly or primarily in cash, you may draw more attention from the IRS. While cash transactions have been declining in favor of digital transactions, the IRS still considers cash businesses to be of significant interest. 

Cash transactions are potentially problematic because they sometimes lack a paper trail, such as a receipt or invoice. The IRS is worried the business owner may take payments “under the table” and not report them. 

In the past, the IRS did not require payment platforms like PayPal, Venmo, or Square to report transactions. These apps often use credit card transactions, which are similar to cash in terms of records. However, the IRS recently began cracking down on payments through these platforms.

So that income generated through these apps doesn’t go unreported, the IRS introduced Form 1099-K. Through the form, these platforms must report all transactions to the recipient of the money and the IRS. 

The IRS matches these transaction records with a business tax return. If there are discrepancies, the taxpayer may face inquiries and an audit.

2. Excessive Losses

Businesses usually exist to make a profit, and they are always required to pay a portion of that profit in taxes, but how much varies depending on the type of business and the amount of loss the business experiences in the fiscal year.

While businesses may lose money for various reasons, recurring losses usually get the IRS’s attention. This is especially true if the owner of several companies loses money in one to offset the income from another. 

Excessive losses are a big IRS red flag for small businesses.

3. Vehicle Deductions

The vehicle deduction for a business is a legitimate and important asset for business owners who use one or several cars for business purposes. Unfortunately, this is one of the most likely reasons a business audit will occur. 

The IRS views vehicle deductions as one of the most abused deductions available to businesses. Vehicle use must be backed up with thorough and timely written records. This is especially important when the vehicle is not used solely for business purposes.

Any vehicle deductions that appear excessive to the IRS will almost certainly flag an audit. In an audit, a lack of proper documentation will result in the disallowance or significant reduction of the deduction, which can result in additional taxes, penalties, and interest.

4. Meals Deductions and Entertainment

Business meals are generally fifty percent deductible. In 2021 and 2022, they were one hundred percent deductible. However, entertainment, such as tickets to sporting events, country club memberships, and similar expenses, is not deductible.

As with vehicle deductions, writing off excessive amounts for meals and taking deductions for entertainment expenses will likely draw IRS inquiries. To fully deduct meals, you must thoroughly document them in writing, including:

  • The receipt 
  • The location
  • The amount
  • The names of people attending
  • And the business purpose of the meal

Without the above details, the deduction will likely be thrown out. Lunch breaks while working that do not include some business purpose are not deductible.

5. Home Office Deduction

Small business owners can deduct a portion of their home mortgage interest, property taxes, utilities, and insurance if they use a part of their home regularly and exclusively for business conduct. This deduction does not apply if the owner has an office they regularly go to outside the home.

The amount of the deduction is related to the square footage of the home. The IRS tends to flag this activity if the business portion of the house results in dollar amounts that seem excessive compared to income. 

The type of business may also be a factor that draws the IRS’s attention.

6. Reasonable Salary

In the case of an S-Corporation, tax law provisions allow the business owners to reduce the amount of self-employment tax (Social Security and Medicare) a partner or sole-proprietor would have to pay. 

However, the IRS requires that the owner(s) of the S-Corporation take a reasonable salary (determined by several factors).

If you file a tax return with no or an unreasonable salary reported, the IRS will likely look at the return, especially as the company’s income increases.

Avoiding IRS Red Flags and Audits

Most taxpayers never experience an IRS audit. However, being informed and prepared is essential for all business owners. 

The best way to prevent an audit is to follow tax laws and pay attention to IRS red flags for small businesses. A tax professional, such as a Certified Public Accountant, can help with these considerations.