10 Red Flags That Can Cause a Tax Audit
There are plenty of common audit triggers that business owners know to avoid. Never mix your business and personal finances. Don’t deduct things without receipts. Most of these preventative measures come down to common sense.
However, every year countless businesses get hit with an audit they never saw coming, and it ends up wasting their precious time and money. Where did they go wrong? Here are 10 little-known audit triggers that every business should know (and some suggestions on how to avoid them):
1. Having more contractors than employees.
It’s tempting to classify your workers as contractors rather than employees, since it can alleviate your business from the stress of handling payroll taxes. The IRS is on the lookout for businesses that mislabel workers to cut corners, and it is especially suspicious of businesses that have a lot of contractors. Make sure that your company is properly classifying its workers here.
2. Claiming “miscellaneous” deductions.
If you want to avoid an audit, do your best to avoid claiming too many deductions categorized as "miscellaneous" or “other” under Schedule A. Instead, itemize your expenses in the most relevant categories in Schedule C, and if you have a more unique deduction, do your best to clearly explain what it is.
3. Extremely high executive compensation.
Because high salaries reduce a company’s overall income (and therefore their overall tax liability), the IRS takes a close look at high-income earners and shareholder-employees in C corporations. Learn more about how to prevent scrutiny for “unreasonable compensation” here.
4. An inconsistent social media profile.
Yes, you read that correctly. If auditors are suspicious of unusually high deductions, they will seek out any available information to corroborate your tax claims; sometimes, this involves looking at your social media activity. So if you are planning to deduct business trip expenses on your taxes, be careful about tweeting photos that make it look like a party vacation rather than a professional excursion.
5. Family members on your payroll.
It’s certainly not uncommon to hire a family member, but the IRS will want to make sure you’re not simply trying to get more money out of the business or give family members gifts with less tax liability. If you have any family members working for you, make sure they are actually working the hours specified and aren’t suspiciously under-qualified or inactive in their position.
6. Reporting your net income rather than gross revenue.
A lot of business owners unintentionally report their net income on Schedule C rather than their gross income from sales. For example, if someone purchases your product on Amazon, you may receive an Amazon Payment with the processing fee already taken out. You should report your gross income (the total amount before the fee was taken out) in Part I, and then report the processing fee as an expense in Part II.
7. Excessive home office deductions.
Although the IRS has slightly loosened its grip on home office deductions, they are still widely considered a red flag if you are claiming a hefty deduction in comparison to your business income. Be especially wary if you are claiming:
- Both a home office and a rented office space
- More than 50% of your home
- A lot of expenses for home maintenance and utilities
8. Missing any tax-related deadlines.
This one should go without saying, but failing to meet any deadlines set by the IRS makes you appear inconsistent and increases your likelihood of an audit. This doesn’t only apply to your annual tax returns; other deadlines, such as your quarterly estimated tax payments, are just as important.
9. Using the wrong accounting method.
There are two basic accounting methods, cash accounting and accrual accounting. Most companies can use the accrual method, but not all companies should use the cash accounting method. Learn the difference between the two, and make sure that you are using the correct system before filing.
10. Self-employed travel and entertainment.
Being self-employed or a sole proprietor makes you a bigger target for the IRS right off the bat. You will need to meet rigid substantiation rules in order to deduct meals, flights, hotels and other travel expenses. Especially when deducting entertainment and food expenses, keeping a receipt is not always enough; keep detailed records of the location, who was in attendance and the purpose of the gathering.
The Final Step
If you really want to avoid being flagged by the IRS, one of the best things you can do is e-file. Using online software significantly reduces your chance of an audit, since all of your numbers (and errors) will be checked by the system before submitting. Tax software like TurboTax can point out potential red flags and help predict your likelihood for an audit, so you can clear up any issues before filing. E-filing also reduces the risk of being flagged for illegible or unclear handwriting.
If your taxes are especially messy, consider completing a risk assessment with an accountant. If you are at high risk of an audit, your tax preparer can suggest ways to lower your odds and can help you rest easier when April rolls around.
Article by Rochelle Bailis