IRS Audit Red Flags: 10 Triggers to Avoid as a Small Business Entrepreneur
Few things that scare a business owner more than the word “audit”.
Did just seeing that word get your heart pumping a little faster and your palms feeling a little sweaty?
I have good news and better news.
The good news is there’s still time to get your books in order so you don’t get audited in 2023.
The better news is I’ve put together 10 red flags for you to look out for so you can avoid triggering an IRS audit next year.
Keep reading to find out what these red flags are so you can skip out on the audit next tax season!
Note: These are some common red flags that may trigger an IRS audit. This list is not comprehensive and is not intended as tax advice. Please consult with your financial expert for advice on your specific tax situation.
Who Gets Audited by the IRS?
If you think that getting audited by the IRS depends on the luck of the draw you’re only partly correct. The IRS employs a specific algorithm to review tax returns. This algorithm compares your tax return against a set “norm” and assesses whether or not it is a risky return. Based on certain, predetermined criteria that your tax return fulfills (or fails to fulfill), the algorithm will then recommend an audit.
After this stage, whether you ultimately get audited depends on the manpower the IRS has available and the luck of the draw. The new laws outlined in the Inflation Reduction Act recommend hiring more IRS agents – which means in 2023, there may be a higher chance of an audit if you have an unusual tax return.
So what can you do? Look out for and avoid these 10 red flags in your tax return!
Tempted to record every single meal you had with your biz bestie as a business expense?
Wondering if you can claim on that trip you took to visit your mom because you also “checked out an event space for a potential retreat you’re thinking about hosting”?
Big deductions for meals and travel are a BIG red flag that could trigger an audit by the IRS. If you have minimal business expenses in other areas but are claiming a significant deduction on “meals and travel”, you could be inviting an audit.
IRS Red Flag #2: Home Office Deduction
Working from home and looking to claim a home office deduction? This could potentially be a red flag that triggers an audit of your business.
“If you use part of your home exclusively and regularly for conducting business, you may be able to deduct expenses such as mortgage interest, insurance, utilities, repairs, and depreciation for that area.” – IRS
This deduction is available for homeowners and renters, but certain restrictions apply. To list your home office as a deduction on your tax return, it needs to fulfill two requirements: 1) Regular and exclusive use, and 2) Principal place of your business. You will need to keep records to prove your usage of this space and the costs incurred to claim this.
IRS Red Flag #3: Mixing Personal and Business Deductions
Don’t have a separate bank account for your business and personal expenses? You may be setting yourself up for an audit! One of the most common IRS red flags among small business owners is the mixing of personal and business deductions.
It may be easier to manage your business expenses from your personal account but this opens you up for an audit. When it is not immediately apparent which expenses are personal and which are for your business, the IRS may choose to reject all your deductions. Save yourself the trouble and keep business separate from personal expenses to make record-keeping easier!
IRS Red Flag #4: Consecutive Losses
Running a profitable business is tough work, and times are tough so occasional losses are to be expected. However, if your business has been chalking up losses year-on-year for multiple consecutive years, you can be sure the IRS will be digging deeper into your books.
Business owners who register losses in their business (expenses higher than income) may find that the IRS classifies their business as a hobby – which means that losses are not claimable on your tax return. If your business has not been profitable for a few years now, it may be advisable to ensure your records are in order to prove that it’s not just a hobby!
IRS Red Flag #5: Misclassifying Contractors
You may have people working in your business but are they independent contractors or employees? One thing to watch out for when filing your tax return is classifying people working in your business correctly. If you misclassify independent contractors when they should be employees instead, this may raise some red flags with the IRS.
When you misclassify workers in your business, you may be liable for employment taxes for the worker, so be sure to check which category your workers fall into.
IRS Red Flag #6: Underreporting Income
Every year, the IRS uses an automated system (the Automated Underreporter) to compare what you list on your return to reports they receive from other third parties. If this system discovers a discrepancy, the IRS will issue a Notice CP2000 for you to correct the errors. However, when this happens, there is also a chance that the IRS may start investigating your entire business to uncover other aspects that do not conform with regulations.
IRS Red Flag #7: Not Paying Yourself a Salary
S Corps Owners, something you may be doing may trigger a red flag – not paying yourself a reasonable salary. As an owner of an S Corp, you need to be paying yourself a salary within certain guidelines and reporting this salary on Form W-2. As a rule of thumb, you should be drawing a salary in line with your training and experience, the duties and responsibilities you carry out in the organization, and what comparable businesses pay for similar services.
IRS Red Flag #8: Excessive Expenses
Imagine you record an income of $50,000. If you record $150,000 in expenses, your tax return is going to raise some red flags with the IRS. Declaring unusually large or excessive expenses in your business is a sure way to call in an audit.
The IRS may read these expenses as not being in line with your business model or disproportionate to your income and may start looking at your tax return in more detail. Make sure you avoid this situation by paying close attention to the expenses you include.
IRS Red Flag #9: Vehicle Deductions
Hoping to claim the entire cost of your vehicle as a deduction for your business? Think again. As a small business owner, claiming 100% exclusive use of a vehicle for your business is difficult to prove and may be an audit red flag for the IRS. It may be more practical and feasible to claim only a portion of the costs of using and operating your vehicle for business use. To do so, you can either use the Standard Mileage Rate or the Actual Expenses method – be sure to check which method you qualify for first!
IRS Red Flag #10: Gross Income Above $100,000
Making a large income in your business is fantastic, but unfortunately, it also raises your chances of being audited. From my experience working in the IRS and as a tax specialist, I have observed that once your gross income crosses the $100,000 threshold, your odds of being audited also increase significantly.
If you’re making this amount (or more!) in your business, there’s no need to panic – simply be sure to keep meticulous records so you come out on the right side of an audit! Hiring a professional will make this much easier.
How to Avoid Getting Audited
An audit is not fun for any small business owner. Apart from the stress and anxiety of being selected for an audit, you may also find that you end up on the wrong side of an audit and have to pay large sums in penalties.
By looking out for these 10 common red flags that trigger an audit, you can reduce your chances of being audited. Another way you can do that is by getting your book in order. Why take the risk of doing your own bookkeeping and potentially getting audited? Hire a professional to review your books and records and sleep better at night knowing that your tax returns are problem-free.
Interested in getting a professional to look at your books? Book your free consultation call with Exceptional Tax Services today!