An Internal Revenue Service (IRS) audit is usually rare, and the reasons for an audit are not always clear. However, certain factors may cause the IRS to audit a business. Here are six IRS audit red flags a small business should avoid.
6 IRS Audit Red Flags to Avoid
Taxpayers who file the following IRS forms should consider these red flags.
- C-Corporation (Form 1120)
- S-Corporation (Form 1120S)
- Partnership (Form 1065)
- Sole-Proprietor (Schedule C of Form 1040)
Red Flag #1: Cash Businesses
Many businesses operate strictly or primarily in cash. While cash is on the decline in favor of digital transactions, the IRS still considers cash businesses to be of significant interest.
In their view, cash transactions aren’t always backed up by a paper trail such as a receipt or invoice. The business owner may then have the opportunity to take income “under the table” and not report it.
Further, the use of payment platforms (such as PayPal, Square, etc.) has in the past not been required to report transactions to the IRS. Most of these are credit card transactions, which are not all that different from cash.
The past few years have seen the introduction of Form 1099-K. This requires these platforms to report all transactions to the recipient of the money and the IRS.
The IRS matches their records with a business tax return. If their records show more, the taxpayer will have to respond to their inquiries and possibly face an audit.
Red Flag #2: Excessive Losses
The IRS assumes businesses exist to make a profit and pay a portion of that profit in taxes. While businesses certainly may lose money for various reasons, excessive or recurring losses over a while will usually get their attention.
This is especially true in situations where the owner of several businesses may lose money in one to offset the income from another.
Red Flag #3: Vehicles
Taking a vehicle deduction for business use is certainly legitimate. However, it can be argued that this, along with the next two red flags (to a lesser extent), is the most likely reason a business audit will occur. The IRS views vehicle deductions as one of the most abused deductions available to businesses.
This can be a highly complex discussion. Still, in general, the use of a vehicle must be backed up with thorough and timely written records. This includes if the car is not used 100% for business, to qualify for the deduction. Any deductions that appear excessive will almost certainly flag an audit.
In an audit, lack of proper documentation will result in the disallowance or significant reduction of the deduction, which can result in additional taxes, penalties, and interest.
Red Flag #4: Meals and Entertainment
Meals are legitimate deductions (in prior years, only deductible 50% but 100% in 2021). Entertainment, such as tickets to sporting events, country club memberships, etc., is not deductible. The same thinking applies here as with vehicle expenses. Excessive meal amounts or deducting entertainment expenses will likely draw IRS inquiries.
To fully deduct meals, all meals must be documented in writing. The receipt must have the location, amount, and the names of the people attending and the business purpose of the meal. Without these, the deduction will likely be thrown out.
Remember, the IRS does not consider going out to lunch without a business purpose (i.e., because you are working and get hungry) deductible.
Red Flag #5: Home Office Deduction
A business owner can deduct a portion of their home mortgage interest, property taxes, utilities, and insurance for the part of the home used regularly and exclusively for business conduct.
This does not apply if the owner has an office that they regularly go to outside the home. The IRS allows actual amounts or a safe harbor alternative based on a dollar amount based on the square footage of the home used.
The red flag here is if the business portion results in dollar amounts that may seem excessive compared to income. The type of business may be a factor as well.
While difficult for the IRS to determine, it would seem more likely a self-employed plumber without a formal place of business would have a section of the home devoted exclusively to storing parts or equipment. On the other hand, a service business may more likely be operating out of a room with other uses or from a kitchen table.
Red Flag #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.
Final Thoughts on Small Business Audit Red Flags
IRS audits are uncommon. Most business taxpayers will never experience one.
However, current discussions in Washington may see increased funding for the IRS to increase agents available to perform audits, mainly of wealthy businesses and individuals.
The best way to prevent an audit is to follow the tax laws. Make sure you pay proper attention to the IRS audit red flags discussed above. A tax professional, such as a Certified Public Accountant or Enrolled Agent, can help with these considerations.