While the overall risk of an individual tax audit is low, the odds go up when you file a business tax return.
Taxpayers who filed Schedule C, Profit or Loss from Business, faced an audit rate of 1.9% if their gross receipts were $25,000 to $100,000 in their 2014 return and an audit rate of 2.3% if their gross receipts were $100,000 or more.
Further, filing business tax forms and having an income between $200,000 and $1 million substantially increases your risk of a field audit, where the IRS will want to meet with you at your place of business instead of corresponding with you about questionable items by mail (a correspondence audit.)
In fact, if your business is structured as a C corporation or S corporation, any audit is almost certain to be a field audit.
C corporations with total assets of less than $10 million and multi-member LLCs face a considerably lower audit risk overall, however.
So do partnerships, which were audited at a rate of just 0.4% for the 2014 tax year.
Regardless of your business structure, making certain choices and certain mistakes when you file your taxes will make you more likely to be audited and more likely to owe back taxes, penalties, and interest.
In consultation with your accountant, while preparing your return, you can avoid key mistakes and put together excellent records to minimize your chances of being audited and limit the time and money your business could spend if you do get audited.
For example, if you got a small business loan last year, you can usually deduct the interest payments as a business expense, but you must follow the IRS’s rules for deducting business interest.
If you’re thinking about getting a loan in 2020, you won’t have to worry about the tax implications until next year.
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Read on to learn about this year’s top small business IRS audit triggers:
What Audit Risks Do S Corporations Face?
Gail Rosen, a Certified Public Accountant in Martinsville, NJ says that S corporations that pay their owners no salary or an unreasonably low salary will attract the IRS’s attention.
“Many taxpayers try to avoid or minimize self-employment taxes by setting up an S corporation for their business,” she says. “The IRS is actively looking for shareholder-employees who take salaries that are too low.”
“Instead of taking a salary, the shareholders take profit distributions from their company and avoid self-employment tax of 15.3%,” Rosen explains. “If you have large profits and low or no officers’ salary, then you are opening yourself up for an audit.”
George Connelly, who heads the tax controversy practice for the national law firm Chamberlain Hrdlicka, says S corporation shareholders can protect themselves by making sure the compensation they claim is in the ballpark for the size and success of the business.
He adds that an S corporation audit often starts with the audit of an individual who is an S corporation shareholder rather than with an audit of the actual company.
What Do Businesses with Independent Contractors Need to Know about Audit Risk?
Rosen says that the IRS is also on the lookout for companies that pay their employees as independent contractors.
“It is very common for businesses to treat their workers as independent contractors, when they should, in fact, be paid as an employee,” Rosen says. “The business saves money by not having to pay the matching payroll taxes and not having to pay benefits.”
Simply having a large number of independent contractors on your business tax return may flag your business for an audit.
States frequently audit this issue because when a business has independent contractors rather than employees, it avoids paying state payroll taxes like unemployment and disability insurance, Rosen explains.
If the state finds that a business has misclassified its workers as independent contractors, it will often notify the IRS of the violation, which can then lead to a federal tax audit.
Read the IRS’s criteria for categorizing workers to make sure your company is in compliance.
What Red Flags Does the IRS Look For on Sole Proprietors’ Tax Returns?
Raymond Haller, a tax partner at the accounting firm Grassi & Co. in Jericho, NY says that “if you report income on a schedule C because you are a sole proprietor, your chances of being audited greatly increase because of perceived abuses with auto expenses, home offices, travel and entertainment, day trading, and hobby losses.”
He cautions that while ordinary and necessary business expenses are deductible, personal expenses or personal use of business property is not deductible.
Sole proprietors must keep their business and personal lives separate.
Haller says these taxpayers make easy targets for the IRS since they typically keep awful, if any, records of their Schedule C and home office expenses.
How Can Cash Businesses Limit Their Audit Risk?
Government studies have found that taxpayers who can determine their own reported income are at increased risk of underreporting their income and not paying as much tax as they really owe.
This is particularly true for businesses that conduct most of their transactions in cash, because there is no trail to easily trace these transactions like there is for check, ACH transfer, and credit card transactions.
But the IRS does have ways to identify whether your cash business is underreporting its income, such as:
- If the income your business reports can’t support your lifestyle or cost of living.
- If your business continues to operate despite reporting losses every year.
- If your bank balances and/or business assets increase despite your business reporting losses.
- If your business has unusually low annual sales or unusually low-profit margins compared to similar businesses.
Besides reporting all the cash income your business receives, you also need to file Form 8300 for any cash transaction over $10,000, Haller says.
Failure to do so will result in substantial penalties; the IRS wants this information to help detect financial crimes.
If you have a cash-intensive business, you can read online about the IRS audit process for cash businesses.
The Bottom Line
Many small businesses face an increased risk of being audited by the IRS because they are in control of what income and expenses they report.
This creates the temptation for abuse by dishonest taxpayers who want to claim a lower income than they actually earned or higher expenses than they actually incurred in order to lower their tax bill.
Plus, the way your business is structured and the types of tax forms you file can heighten your audit risk further.
At the end of the day, the best defense against a small business tax audit is, to be honest:
Keep complete, organized, and accurate records, and consult with a tax professional to prepare your tax return.
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