10 Red Flags to Avoid an IRS Audit

As a small business owner, receiving an audit notice from the IRS can be a nightmare. The thought of being scrutinized for errors or inaccuracies in your tax returns can cause unnecessary stress and anxiety. However, it's important to know that there are certain warning signs that may increase your chances of being audited by the IRS. I've compiled 10 warning signs for an IRS audit that you should watch out for:

1. Big deductions for meals and travel.

One of the biggest triggers for an IRS audit is excessive deductions for meals and travel. If your business has minimal expenses in other areas, but you're claiming a significant deduction for these expenses, you're likely inviting an audit. The IRS closely scrutinizes these deductions because they are often abused by taxpayers who claim personal expenses as business expenses.

To avoid this, make sure you keep detailed records of your business-related meals and travel expenses, including the date, time, place, and purpose of each expense. Only claim expenses that are directly related to your business and keep personal expenses separate. Additionally, make sure you understand the rules around meal and travel deductions so you can substantiate your claims if necessary.

2. Home office deduction.

This deduction is available to both homeowners and renters but has specific requirements that you need to meet. In order to claim the home office deduction, you must use a portion of your home regularly and exclusively for business purposes.

To avoid this, make sure you understand the rules around claiming the home office deduction. Keep detailed records of the square footage of your home office and the total square footage of your home, as well as all expenses related to your home office. Only claim the portion of your expenses that are directly related to your home office and avoid claiming personal expenses.

3. Mixing personal and business deductions.

Keeping your business and personal expenses separate is crucial for accurate record-keeping and reducing your chances of being audited.

To save yourself the trouble, use separate bank accounts and credit cards for your business and personal expenses. Additionally, make sure you understand the rules around what constitutes a legitimate business expense so you can accurately classify your expenses. If in doubt, consult with a bookkeeper or tax professional to ensure you are claiming the correct deductions.

4. Consecutive losses.

If your business has been chalking up losses year-on-year for multiple consecutive years, you can be sure the IRS may start scrutinizing your tax returns more closely. While it is not uncommon for a business to operate at a loss in the early years, reporting losses year after year can indicate to the IRS that your business is not a legitimate business but rather a hobby or personal endeavor.

If your business is operating at a loss, be prepared to show that you have a reasonable expectation of making a profit in the future.

5. Misclassifying contractors.

When you misclassify workers as independent contractors in your business, you may be liable for unpaid payroll taxes for the worker and added penalties. The IRS has specific guidelines that outline the differences. It's essential to know which category your workers fall into and ensure that you're treating them appropriately.

6. Underreporting income.

Underreporting income is a serious offense that can land you in hot water with the IRS. This can happen accidentally, such as forgetting to include a 1099 form, or intentionally, such as deliberately leaving out income to avoid paying taxes. Regardless of the reason, underreporting income is a red flag for the IRS and can trigger an audit.

The IRS uses an automated system (the Automated Underreported) to compare what you list on your return to reports they receive from other third parties. If this system discovers a discrepancy, the IRS will issue a Notice CP2000 for you to correct the errors. To avoid underreporting income, be sure to keep accurate records of all your income sources and report them on your tax return.

7. Not paying yourself a salary.

If you are an owner of an S Corp, you need to be paying yourself a salary within certain guidelines and reporting this salary on Form W-2. Failure to do so may trigger an audit. To avoid this, make sure you are paying yourself a reasonable salary based on your job duties and industry standards. Consult with a tax professional to determine what a reasonable salary would be for your business.

8. Excessive expenses.

The IRS may read these expenses as not being in line with your business model or disproportionate to your income and may start looking at your tax return in more detail.

For example, if you run a small online store, claiming a large deduction for travel and entertainment expenses may raise eyebrows at the IRS. Similarly, claiming a deduction for a luxury car when a more modest vehicle would suffice is also a red flag.

To avoid this, make sure you only claim expenses that are necessary and reasonable for your business. Keep detailed records and receipts to substantiate your claims and be prepared to explain them if questioned by the IRS. A good rule of thumb is to ask yourself whether the expense was directly related to your business and whether it was necessary for you to incur it in order to earn income.

9. Vehicle deductions.

As a small business owner, Claiming 100% exclusive use of a vehicle for your business is difficult to prove and may be an audit red flag. Keep accurate and detailed records of your vehicle usage and milage and don't get rid of any receipts and documentation related to the vehicle. Make sure they're business-related. Bookkeeping and tax professionals can help you determine the appropriate deduction for your vehicle expenses.

10. Gross income above $100,000.

Making a large income in your business is fantastic, but unfortunately, it also raises your chances of being audited. The IRS has limited resources, so they tend to focus their audits on taxpayers who have a higher likelihood of underreporting income or claiming improper deductions. Make sure you're keeping accurate records of your income and expenses and that you're reporting everything correctly.

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An audit is not fun for any small business owner. Apart from the stress and anxiety of being selected for an audit, you may also find that you end up on the wrong side of an audit and have to pay large sums in penalties.

To minimize your chances of being audited, it's essential to look out for these warning signs and take steps to address any issues. One way to reduce your risks is to hire a professional bookkeeper or accountant to review your books and ensure that your tax returns are accurate and problem-free. By taking proactive steps to keep your finances in order, you can sleep better at night and focus on growing your business.

If you need help with your bookkeeping, please schedule a call with us today. Our team of experienced professionals is here to help you keep your books in order and minimize your chances of being audited.

Balanced Bear Bookkeeping, LLC

balancedbearbookkeeping.com

torie@balancedbearbookkeeping.com