IRS Red Flags to Avoid
Why does the Internal Revenue Service audit some small businesses while ignoring others? What actions can business owners take that may result in a small business tax audit? Sometimes it’s by chance, but certain financial practices can lead to an IRS audit for a small business.
In recent years, the IRS has audited less than 1% of all individual returns, so most taxpayers can relax. However, if you file a Schedule C to report a business’s profit or loss, your chances of being scrutinized by the IRS increase.
While the chances of an IRS audit for a small business are low overall, some factors can significantly increase your organization’s likelihood of being targeted. The IRS looks for many red flags to identify taxpayers and businesses more likely to have tax inconsistencies.
Take your time reviewing everything, ensuring all your reported taxable income, tax credits, and supporting documents are in order. You can also avoid spending a significant amount of time digging up old records, potentially saving a significant amount of money.
Here is the list of IRS red flags you should avoid:
1. Businesses that only take cash as payment.
If your company operates solely or primarily in cash, the IRS may be more interested in you. While cash transactions have been declining in favor of digital transactions, the IRS still has a strong interest in cash businesses.
Cash transactions are potentially problematic because they sometimes lack a paper trail, such as a receipt or invoice. The IRS is concerned that the business owner will accept payments “under the table” and fail to report them.
Before, the IRS did not require payment platforms like PayPal, Venmo, or Square to report transactions. However, the IRS recently began cracking down on payments through all of them.
The IRS introduced Form 1099-K to ensure that income generated by these apps is properly reported. Through the form, these platforms must report all transactions to the recipient of the money and the IRS. These transaction records are matched with a business tax return by the IRS. The taxpayer may be subjected to inquiries and an audit if there are inconsistencies.
2. Making a substantial amount of money
As your income rises, your chances of being audited by the IRS increase dramatically. The audit risk is higher for sole proprietors who report at least $100,000 in gross receipts on Schedule C., And millionaires face the most audit heat.
The IRS’s high-wealth examination unit has even returned to the fray. The IRS has a specialized group that handles audits of the super-rich. A bit more than a year ago, we had a similar discussion.
3. Reporting Net Losses Over Several Years
If your business has reported net losses in three or more of the past five years of operation, the IRS may want a closer look at your books. The IRS typically assumes that businesses that profit between three to five years are legitimate. As a result, the IRS may consider businesses that have had multiple net losses in recent years to be potential violators of hobby loss rules.
The IRS wants to know if your business has “an actual and honest profit motive” rather than being a hobby that takes advantage of tax breaks. The problem is that these hobby loss rules may prevent you from deducting certain deductions that could have saved you money. As a result, you’ll want to ensure that receipts and documentation support any business deductions you claim.
4. Excessive Income Deductions
Itemized deductions on tax returns are not uncommon for small business owners. Home office deductions, internet bills, travel costs, and vehicle use are some common tax deductions that business owners can claim.
These tax breaks can significantly reduce a business owner’s tax liability. However, having too many deductions can raise red flags and lead to an IRS audit.
According to the IRS, a legitimate business expense should be ordinary and necessary to be deducted.
5. Amended Returns
The IRS will almost certainly scrutinize amended returns more closely. Filing an amended return, mainly if it results in a significant tax reduction, almost always results in a second look by the IRS.
Although it does not guarantee that your return will be audited, an amended tax return red flag generally indicates that someone at the IRS will check to ensure that the return was completed correctly.
6. Deductions for Vehicles
The vehicle deduction is a legitimate and valuable asset for business owners who use one or more cars for business purposes. Unfortunately, this is one of the usual reasons for a business audit.
The IRS considers vehicle deductions one of the most abused business deductions. Detailed and timely written records must support vehicle use. This is especially important when the vehicle is not solely used for business.
Any vehicle deductions that appear to the IRS to be excessive will almost certainly trigger an audit. In an audit, a lack of proper documentation will result in the deduction being disallowed or significantly reduced, which can result in additional taxes, penalties, and interest.
7. Huge Deductions on Food, Transportation, and Entertainment
Is it for work or pleasure? A large Schedule C write-off for restaurant tabs and hotel stays will raise red flags, especially if the amount appears to be excessive for the business or profession.
To be eligible for food or entertainment deductions, you should keep detailed records that document the amount, location, number of people present, business purpose, and nature of the discussion or meeting.
8. Large Donations to Charities
Donations are an excellent way to support worthy causes and assist those in need. Unfortunately, the IRS is skeptical of small businesses that donate to charity. If your company suddenly increases the amount of money donated in a given year, the IRS may want to ensure that these donations aren’t an attempt to circumvent the tax code.
Maintaining consistent donations year after year is one way to avoid IRS scrutiny. By gradually increasing your charitable contributions, the IRS will have less reason to suspect that you are attempting to avoid paying small business taxes.
The vast majority of taxpayers never face an IRS audit. All business owners, however, must be informed and prepared.
If you want to avoid an audit, the best way is to adhere to tax laws and be aware of IRS red flags for small businesses. These considerations can be assisted by a tax professional.