How often are small businesses audited? What alerts the IRS to come knocking at your door? While audits are sometimes simply random, and cannot be entirely avoided, the IRS notices a variety of red flags – audit “triggers” that can be prevented.
Unfortunately, many small business owners do not know the red flags that initiate an audit or how to avoid these mistakes. Below, we seek to provide clarity for business owners.
Common IRS Red Flags
Be Wary of Entertainment Spending
If you make a habit of taking potential clients out to concerts or sporting events, that’s fine – however, the government eliminated business-related entertainment deductions in 2017, so plan to spend your own dime.
To a certain extent, meals presented to a potential client, current customer, consultant, or similar business contact are still considered viable for deduction purposes. If you, the taxpayer, are present and do not order extravagant food or beverages, 50% of the meal may be deducted. In general, be wary of claiming entertainment spending-related deductions. The difference between a baseball game outing and a lunch meeting could alert the IRS.
Finally, always keep track of receipts and detailed records of expenses. In the event an audit is requested, these documents will be critical to prove your claimed deductions.
Be Careful with Deductions
Small business owners spend countless hours working on both daily operations and planning future success of their companies. Thus, business owners should absolutely take advantage of every business deduction legitimately available!
Be careful to stop there, however. The IRS uses Discriminate Income Function to compare the number of deductions your business takes compared to others in your industry. If you take 200 deductions, while the average company in your industry takes 20, you will likely hear from the IRS.
As a rule of thumb, be cautious with “miscellaneous deductions” or extraneous deductions taken from small expenses in the name of saving money. The IRS states that deducted expenses should be “ordinary and necessary” for your specific industry.
Vehicle mileage and business travel are among the most misused deductions – thus, they are scrutinized by the IRS. If you are unsure about the proper expenses to deduct, or if this is your first year in small business management, consult an experienced financial professional for guidance.
Always File on Time
Beyond accruing penalty fees, consistently filing your taxes late can provoke unwanted scrutiny from the IRS. As a small business, if your goal is to file properly and sit below the radar, filing on time is necessary. Do not wait until the last minute to start the process! Unforeseen challenges may arise and filing late is not worth the red flags raised. If you foresee late filing, request an extension.
In additional to filing on time, file electronically. Paper returns are much more likely to contain errors.
In general, small businesses face audits more often than corporations. Why? Because incorporating can demonstrate a higher level of financial and operational competence. One knowledgeable legal resource states:
Schedule C income tax filers, who are self-employed taxpayers, face one of the highest risks of being audited by the IRS. This is because the IRS suspects self-employed people report incomes lower than actually earned and claim deductions that weren’t earned. Incorporation reduces the chance the IRS will select your return for an audit.
Less chance of being audited is only one of the many reasons to incorporate or form an LLC. A few additional benefits include more available deductions, protection of personal assets, and the increased likelihood of securing loans. If you were on the fence about becoming a corporation, protection from an audit can be added to your list of “pros.”
Be Cautious of Sudden Charity
If you give sudden large sums to charity out of the blue, the IRS may view this action as suspicious. Some businesses attempt to give to charity to avoid taxes, an obvious abuse of tax code. If you plan to donate, give gradually year-over-year rather than in one large sum.
If Paying in Cash, Record Every Transaction in Detail
Generally, businesses operating in cash – especially for large transactions, such as purchasing a company vehicle or expensive business equipment – receive additional attention from the IRS. Cash is simply more difficult to verify.
While paying in cash is okay, be sure to keep a precisely detailed record of every cash transaction, creating a viable paper trail. If you are not dedicated to cash-only transactions, consider utilizing a business credit or debit card for all company payments. Credit or debit transactions make for an easier time filing and proving transactions, should the need arise.
Always Report ALL Taxable Income
Although this point is a given, it is worth mentioning to emphasize importance. Always report all taxable income made in the United States to the IRS. Period. If small business owners are suspected of withholding income of any kind, an audit is almost guaranteed. Thus, be meticulous in the process of calculating and reporting income, even cash payments, capital held in offshore bank accounts, etc.
Additionally, if you utilize digital currency within your business operations, such as bitcoin, be prepared for heightened IRS scrutiny.
Provide Reasonable Salaries
Small business owners paying employee shareholders must be cautious about providing reasonable salaries, based on the industry average. The IRS pays special attention to unusually high shareholder salaries.
Unfortunately, the IRS also tends to focus on high salaries in general – be prepared for greater chances of an audit as your personal salary increases over time.
Remote Quality Bookkeeping
At Remote Quality Bookkeeping, we are passionate about helping small businesses grow by providing simplified bookkeeping solutions. Our team of experts ensures that every client maintains accurate books and reconciled balance sheets – always.
To learn more, schedule a time to chat with one of our bookkeeping experts or simply give us a call at 866-567-4258!