Few words strike fear into the heart of small business owners like “audit.” 

Although the chances of an IRS audit of your small business’s taxes remain relatively low, that might be changing. In 2020, following a relatively quiet decade for small business audits, the IRS announced it would be ramping up its audit plans in the coming years.

There are “audit red flags” you should be aware of that tend to draw extra IRS scrutiny. Here are some common small business tax audit triggers.

1. High Income Reported on a Schedule C

Due to IRS concerns about blurred personal and business expenses, the audit rate for Schedule C sole proprietorships is higher than other types of companies. 

According to 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 or Loss from Business, Sole Proprietorship) was around 0.6%. That rate more than doubled to 1.4% for Schedule C filers in the same income bracket. And for Schedule C filers reporting over $1 million in income, the audit rate jumped to 3.23%.

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

Many small business owners set up an S-Corp instead of an LLC to avoid the 15.3% self-employment tax. Although they aren’t subject to self-employment tax on distributions, S-Corp shareholders working as employees must receive “reasonable” compensation (reported as wages on a W-2).

Often, the individual tax return of shareholder-employee flags the audit, leading to an investigation of the company. 

The IRS watches out for S-Corps paying shareholder-employees unreasonably low (or even no) salaries. The IRS will compare your compensation to the standard for a similar position in a similar industry, and it’s a big red flag if you’re significantly outside the acceptable range.

3. Pandemic Related Stimulus Payments

Pandemic relief is one of the drivers behind the IRS’s intent to increase audit activity on small businesses. If your business received loans or stimulus from the pandemic measures, expect some additional scrutiny in the next few years. 

Funds distributed through the Paycheck Protection Program or CARES Act were loans intended to be mainly used to continue paying employee payroll, rent, interest, and utilities while businesses were closed. Improperly used funds could turn into taxable income after an audit.

4. Disproportionate Deductions & Excessive Expenses

There is nothing wrong with claiming justifiable business deductions, and they’re an essential way for small business owners to reduce tax expenses. 

However, deductions that are not in line with your business model or disproportionate to your income are a significant tax audit trigger. A large increase in deductions or expenses compared with the previous year is also likely to attract attention.

The IRS has methods and calculations for determining the “right” amount of deductions for each income bracket. Unfortunately, this information is proprietary, and they don’t share it with CPAs or their clients. 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.

Due to frequent misuse, certain deductions draw more IRS scrutiny than others.

Home Office Deduction

Many taxpayers shifted to “work from home” during the pandemic. It’s fair to expect that anyone claiming the home office deduction will be under extra scrutiny in the coming years. 

The home office deduction rules are more complex than many small business owners realize. Complex rules can be challenging to follow and come under increased IRS scrutiny.

The calculation for the home office deduction is based on square footage, and you may only deduct square footage 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. 

Further, you can’t take the deduction if you use that dedicated square footage for any other non-business purpose. For example, if your home office doubles as a guest room, you can’t take any home office deduction.

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 costs in these areas may draw the attention of the IRS. 

The IRS will check to ensure that meal and travel expenses match your type of business. No matter how regularly you meet with clients and prospects, you should only deduct what is ordinary and necessary for the company. 

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

Document everything and keep your receipts so, if necessary, you can prove the meeting’s connection to the business, including:

  • The purpose of the meeting and its connection to your business
  • Time, date, and location
  • A list of the attendees
  • Summary of meeting minutes

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 choose between deducting your actual vehicle expenses (there’s a calculation for this) or your mileage, but claiming both 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 car. However, because 100% business use is unlikely in most cases, claiming full business use for a vehicle is an audit red flag. If this indeed applies to your business, you must be able to back up your claim with mileage logs showing the dates and purpose of every trip.

5. A Large Number of Independent Contractors vs. Employees

States are always on the lookout for businesses with large numbers of independent contractors. So this tax audit trigger often originates with state tax agencies rather than the IRS.

Why? Businesses hire independent contractors instead of employees to avoid paying state payroll taxes—including unemployment and disability. Companies also don’t have to pay federal payroll taxes for these contractors, including the employer portion of Social Security and Medicare.

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

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

However, this doesn’t mean your business can’t use independent contractors, and you must simply ensure you comply with the IRS worker classifications and the standards in your particular state(s). But because there is no single “worker status test,” this can be challenging.

Consulting an employment lawyer is a wise move if you have any concerns in this area.

6. Claiming Continuous Business Losses on a Schedule C

A business’s primary purpose is to make money, and reporting losses year after year is a red flag for the IRS.

Your chances of being audited are lower for the first year or two you’re in business when it’s normal to generate a loss. 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 more a hobby than a business. 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 and inflating your losses 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 potentially 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 to defend those deductions in an audit.

Mistakes, Shortcuts, and Round Numbers

Yes, the IRS checks your math, and too many errors will trigger red flags! Incorrect totals for expenses, missing 1099s, and transposed numbers can get the IRS concerned, even if the mistakes aren’t “big.” 

They are also on the lookout for numbers that are too round. It’s unlikely that all of your figures will end in fives or tens or even thousands, and numbers that are too “pretty” will cause the IRS to want to dig deeper.

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

Many legitimate businesses operate on cash-only or mostly-cash. Barbershops, freelancers, and restaurants still use a significant amount of cash. 

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

You need thorough documentation of all cash transactions should you need to prove to the IRS you’re presenting the complete picture. Don’t forget to file IRS Form 8300 to report cash payments over $10,000.

Why aren’t specialty tax credits like the R&D tax credit and cost segregation on this list? I’ve heard those are tax audit triggers.

John Schnobrich Flpc9 Vocj4 Unsplash 1 - 7 Small Business Tax Audit Triggers Owners Overlook - Tri-Merit

The IRS indeed scrutinizes these credits because they can be abused. 

However, you can feel confident your claim will hold up under IRS scrutiny when a specialty tax partner like Tri-Merit correctly performs an R&D tax credit study or cost segregation study.

If you’re taking an incentive for the first time on a return that’s filed timely, your odds of being audited are no higher than if you weren’t taking the incentive at all. However, amending returns to claim credits that you didn’t previously realize you qualified for can cause the audit rate to go up. You’re essentially asking the Treasury for a refund; of course, they’ll want to double-check your claim.

The more significant challenge with the R&D tax credit is that many smaller businesses and startups don’t even realize they 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? Schedule a discovery call with the R&D tax credit experts at Tri-Merit. We can help you assess if your business may qualify.