Five IRS audit triggers for small businesses

July 15, 2019 by Carolyn Richardson, EA, MBA
distressed business owner looking at paperwork

Running your own business can be the most satisfying and the most terrifying thing you can do. Beyond the upside of being your own boss and doing what you love, there are the downsides like long hours and clients who take their time to pay you. Adding to those woes is the fact that running your own business increases your chances of being audited by the IRS or your state tax agency. 

While the reasons your return is selected for an audit can vary, here are several common audit triggers you should be aware of (and hopefully avoid falling into). 
 


#1: Not Reporting All Your Income 


Depending on your type of business, you may receive a lot of cash − or all your clients may pay you via other methods. Regardless of how you are paid, it is important to report all cash payments you receive, even for those small jobs with a one-time client who does not issue a 1099-MISC.  

As the world becomes more virtual, it is easier for the IRS to determine when you aren’t reporting your income. Third-party payment processors like PayPal must issue forms to you when you go over a certain number of transactions or the total transactions go over a specified dollar amount.
The IRS receives this information as well and can compare it to your reported income. If you come up short, it can trigger an audit. Even if you report all your other income if your business is of a type that typically receives cash for at least some transactions, having your reported income match exactly with what is reported to the IRS is likely to raise a few eyebrows. 

Expenses should be reported accurately as well. The IRS uses standard net profit margin ratios to determine whether taxpayers are reporting all their income, and if your expenses are outsized from your income, it can trigger an audit. If your business is one that frequently would have cash transactions and your income ties exactly to the income reported to the IRS via information returns, you can expect an audit at some point. 

#2: Claiming Losses Every Year to Year 


Another way to trigger an audit is never to show a profit. While it may be true that your expenses consistently outpace your income, if you can’t make money, the IRS will want to know why you are staying in business. Spending money to lose money year after year is not a smart business practice and may indicate to the IRS that you really aren’t trying to make money.  

Many taxpayers pay no attention to the fact their business is losing money every year. But business losses lower taxable income dollar for dollar, and thus reduce tax liability. Sometimes it happens because the taxpayer is not tracking expenses closely enough during the year and does not realize they are losing money until they do their taxes (another bad business practice). Or maybe it’s because they truly love what they are doing and don’t really care if it shows a profit. 

But failing to ever report a profit on your business means the IRS or state may challenge you during the audit on whether this truly is a business.  If you have no profit motive, there is no business, and the IRS will classify it as a hobby. Not only can they remove the loss from your return for the original year under audit, but they will likely go back to previous years’ returns to remove the losses from those as well. And in a double whammy, if you do have income from the activity that is still income to you, you no longer get the benefit of your expenses due to the elimination of itemized deductions. Depending on the amount of the loss and your other income, this can result in a large tax bill.  

While the IRS may claim your business is a disguised hobby, this is one of those ‘grey areas’ of tax law and can be disputed with the examiner. This is why it’s so important to have someone familiar with the rules defending you in an audit and why we offer prepaid audit representation for small businesses. 
 


#3: Failing to Comply with Employment Taxes


business owner worried about an auditWhile many small businesses have no employees beyond their owner, those that have hired employees may find they are struggling with their employment taxes. Before hiring an employee, you need to make yourself aware of what your liability will be for the employment taxes on the wages you are paying. In addition to withholding your employee’s share of FICA and Medicare taxes – which come out of the employee’s wages –, you will have to pay the employer’s share of these taxes. FICA taxes are currently 6.20% of wages, and Medicare taxes are 1.45% of those wages. So, on an employee who makes $1,000 per week, the employer will be assessed $76.50 in additional taxes. That may not sound like much, but it adds up quickly, especially when you have more than one employee. 

More importantly, however, are the withheld taxes for the employee’s portion of FICA and Medicare, and their requested federal and state withholding. Because employers are required to withhold these taxes, they are not actually paying them to the employee but should be depositing them into a trust account to pay them when the employment tax returns are filed. But in the 35 years I’ve been practicing taxes, I’ve seen hundreds of employers who fail to do this. The reasons vary, but usually, it is because there is a cash shortage in the business − so while the net wages might be paid, there is no money set-aside for the withholding and taxes.  

Once you start sliding down the slippery slope of thinking, “I’ll pay the employment taxes later when business is better,” it is hard to recover. Not only do the taxes and withholding due mount up quickly, but once the IRS discovers your failure to pay over these taxes they will swiftly take punitive action which can result not only in liabilities for the unpaid amounts but interest and penalties which can be up to 100% of the taxes due.

 


#4: Incorrectly Reporting or Underreporting Sales or Use Taxes 


If your business is required to collect and pay over sales taxes, your state sales tax agency is likely to initiate an audit which can lead to not only a sales tax audit, but potentially an income tax audit as well. 

The issue here is that collecting the correct sales or use tax can be extremely complicated for a small business. Sales or use taxes can vary not only from state to state but also for each county, and frequently within cities in those counties. And all these differences are additive – the county is taking an additional tax on top of a basic state sales tax rate, and the city is adding another percentage on top of the state and county rates.  

While some bookkeeping and accounting software can calculate the taxes owed, to add to your woes exactly what is subject to sales or use taxes can vary by jurisdiction as well, and software cannot make that determination. Knowing what is taxable in each jurisdiction and at what rate can be a migraine-inducing exercise in frustration. Not only is this true just within your own immediate area and state, but if you are selling out of state, you are likely liable for use taxes to that jurisdiction as well. And they will likely have an entirely different set of rules regarding what is taxable.

 


#5: Deducting Personal Expenses as Business Expenses 


It might seem tempting to deduct that dinner with your husband as a business expense because you spent the whole evening telling him about your plans for your business. But this type of thinking can lead to more and more “fudging” of personal expenses disguised as business expenses. And the deductions most likely to be miscategorized – meals, entertainment, travel, and car use – are also the very ones that require more documentation to sustain in an audit. 

Many taxpayers are unaware that these expenses, which all fall under a particular section of the revenue code, require detailed records of the business purpose. A receipt or credit card receipt is not sufficient. You must also document who you were with, the business purpose of the meeting, the date, and the amount in addition to the receipt. For car expenses, the IRS will also want to see a mileage log with specifics on locations driven to with the business mileage noted, but also your total mileage for the year. 

So, if you’re planning to attend that business conference at Disney World, you’d be wise to keep a copy of the conference program and which courses you attended and separate out your actual business expenses from the expenses of talking along your spouse and kids. Even if you are there on legitimate business, that does not make the additional costs of bringing them with you a business deduction. 

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Carolyn Richardson, EA, MBA
Learning Content Managing Editor

 

Carolyn has been in the tax field since 1984, when she went to work at the IRS as a Revenue Agent. Carolyn taught many classes at the IRS on both tax law changes and new hire training. In 1990, she left the IRS for a position at CCH, where she was a developer on both the service bureau software and on the Prosystevm fx tax preparation software for nearly 17 years. After leaving CCH she worked at several Los Angeles-based CPA firms before starting at TaxAudit as an Audit Representative in 2009. Carolyn became the manager of the Education and Research Department in 2011, developing course materials for the company and overseeing the research requests. Currently, she is the Learning Content Managing Editor. 


 

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irs agent examining a tax return
Besides official IRS examinations, the IRS also conducts other types of tax reviews that are not classified as official audits, and these are far more common.
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Non-refundable credits can reduce your tax liability to zero. Refundable credits can give you money back if the amount of the credit is more than you owe.
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401k loans aren't reported on your federal tax return unless you default on them. Then it becomes a distribution and subject to the rules of early withdrawal.
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