There are few words that strike fear into the heart of small business owners like “audit.” The truth, however, is that the chance of the IRS auditing your small business taxes is relatively low. The audit rate is higher for Schedule C sole proprietorships (due to IRS concerns about blurred personal and business expenses). Even so, there are “audit red flags” you should be aware of that tend to draw extra IRS scrutiny. Here are common small business tax audit triggers.

1. High Income Reported on a Schedule C

As per the 2018 IRS Data Book, the audit rate for people with incomes between $200,000 and $1 million who did not file a Schedule C (Profit of Loss from Business, Sole Proprietorship) was only 0.6%. That rate jumped to 1.4% for Schedule C filers in the same income bracket. For Schedule C filers reporting over $1 million in income, the audit rate increased still more to 3.23%.

2. Low or No Salaries for S-Corp Shareholder-Employees

Many small business owners set up an S-Corp instead of an LLC in order to avoid the 15.3% self-employment tax. S-Corp shareholders aren’t subject to self-employment tax on distributions, but they must be paid “reasonable” compensation if they also work as employees. This compensation is reported as wages on a W-2.

The IRS watches out for S-Corps with unreasonably low or even no salaries paid to shareholder-employees. If your compensation isn’t in the accepted range for the job position and your company’s size, industry and profitability, that’s an audit waiting to happen.

Often, the individual tax return of a shareholder-employee flags the audit, which then leads to an investigation of the company.

3. Disproportionate Deductions & Excessive Expenses

Deductions are important for small business owners, particularly in the start-up years when every penny counts. There is nothing wrong with claiming deductions your business qualifies for. However, deductions that are disproportionate to your business income are a major tax audit trigger. A large increase in deductions or expenses is also likely to get attention.

The IRS has methods and calculations for determining how much in deductions is too much for each income bracket. Unfortunately, this information is proprietary. Even so, you can reduce your risk by only claiming deductions that are “ordinary and necessary” for your line of business. You can read more about this and other rules for business expenses in IRS Publication 535.

There are certain deductions that draw more IRS scrutiny, due to the fact that they’re often misused. These include the home office deduction, meal and travel expenses, and vehicle deductions.

Home Office Deduction

The rules governing the home office deduction are more complex than many small business owners realize. With complexity comes increased IRS scrutiny.

The calculation for the home office deduction is based on square footage. You may only deduct square footage that’s exclusively used for your business. For example, if you have a workstation set up in your living room, you can only deduct the square footage the workstation sits on—not your entire living room. You can’t take the deduction at all if you use that dedicated square footage for any other non-business purpose—for example, if your home office doubles as a guest room.

Meal & Travel Expenses

Meals and travel can be legitimate business expenses, particularly if you often need to meet with clients and prospects. However, higher-than-average expenses in these areas may draw the attention of the IRS. The IRS will consider the type of business you are in and what’s considered ordinary and necessary for that business.

If you’re going to write off travel and meal expenses, you need to be able to prove that they are for business—not personal—purposes.

Document each write-off, including:

  • the purpose as it relates to your business
  • when and where it occurred
  • who was in attendance
  • a summary of what was discussed

Keep the receipts!

Vehicle Deductions

If you’re using a personal vehicle for business, you may be able to deduct the business portion of your car expenses. You can either deduct your actual vehicle expenses (there’s a calculation for this) or your mileage. Claiming both these deductions is a tax audit trigger.

If you have a vehicle that’s used exclusively for business, you may be able to claim a deduction for the depreciation on the vehicle. Claiming 100% business use for a vehicle is an audit red flag, so you must be able to back up your claim with mileage logs showing the dates and purpose of every trip.

4. Large Number of Independent Contractors vs Employees

Employment law concept. Book and gavel on a desk.

This tax audit trigger is different in that it often originates with state tax agencies rather than the IRS.

States are always on the lookout for businesses with large numbers of independent contractors. Why? Businesses don’t have to pay state payroll taxes—including unemployment and disability—for independent contractors like they do for employees. They also don’t have to pay federal payroll taxes for them, including the employer portion of Social Security and Medicare.

Some businesses use this as a way to save money…which can backfire in a big way if those independent contractors are actually employees.

If the state discovers that a business has misclassified their workers, it will often notify the IRS, triggering a federal tax audit on top of the state penalties. Both agencies have a vested interest in making sure payroll taxes are properly paid.

Does this mean your business can’t use independent contractors? No, but you must ensure you’re in compliance with the IRS worker classifications as well as the standards in your particular state(s). This can be challenging as there is no one single test for determining worker status. Consulting an employment lawyer is a wise move if you have any concerns at all in this area.

5. Claiming Continuous Business Losses on a Schedule C

The primary purpose of a business is to make money. If you report losses year after year, that’s a red flag for the IRS.

It’s normal for a startup to take a loss in its first year or two. Your chance of being audited then is lower. However, if you only make a profit in two years out of five, the IRS may take a closer look. They may want to investigate if your sole proprietorship is actually a business, or if it’s a hobby. That’s a concern because while business expenses are deductible, hobby expenses are not. They may also question if you’re taking too many deductions in order to avoid paying taxes.

Sole proprietorships tend to garner more IRS attention due to the thin line between personal and business expenses in these setups. If this is a concern, talk with your accountant about strategies for keeping the two separate, or possibly exploring other business structures.

This doesn’t mean you shouldn’t claim deductions you’re legitimately entitled to. You will, however, need to be vigilant and detailed in your record-keeping in case you need to defend those deductions in an audit.

6. Mistakes and Shortcuts

Yes, the IRS checks your math! Incorrect totals for expenses, missing 1099s, even transposed numbers can get the IRS concerned, even if the mistakes aren’t “big.” Why? The IRS reasons that if you’re taking shortcuts and making mistakes on something as important as your taxes, you might be careless in other financial areas of your business.

7. Large Amount of Cash Transactions

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The IRS tends to scrutinize businesses with large cash transactions as the income is harder to track than credit card transactions, PayPal, checks, etc. They have proprietary methods for determining normal amounts of cash transactions for different types of businesses, and relative to other income you report.

You need thorough documentation of all cash transactions should you need to prove to the IRS you’re on the up and up. You must also file IRS Form 8300 to report any cash payments over $10,000.

Wait, what about specialty tax credits like the R&D tax credit and cost segregation? I’ve heard those are tax audit triggers.

It is true that the IRS scrutinizes these credits because they can be abused. However, when done properly through an R&D tax credit study or cost segregation study from an expert specialty tax partner like Tri-Merit, you can feel confident your claim will hold up under IRS scrutiny.

If you’re taking an incentive for the first time on a timely filed return, your odds of being audited are really no higher than if you weren’t taking the incentive. However, if you’re amending returns to claim credits that you didn’t previously realize you qualified for, you can expect the audit rate to go up. This is logical as you are essentially asking the Treasury for a refund.

The bigger challenge with the R&D tax credit is that many smaller businesses and startups don’t realize they may qualify! Even if you’re not profitable yet, you may be able to apply R&D credits to your payroll tax.

Want to know more? At Tri-Merit we are experts in the R&D tax credit space and can help you assess if your business may qualify. Give us a call at (847) 350-1292 or schedule a consultation today!