Seven Potential Audit Triggers for Small Business

Picture of a red flag just calling out to the IRS to trigger an audit“Time is money” is a commonly heard phrase in the business world, and in the world of small business it can be especially accurate.

Don’t invite an IRS audit of your small business by throwing up unnecessary red flags – the time spent defending yourself in an audit would be better spent growing your business!  So, what sort of red flags can make your business a target?

  1. Report a net loss in more than two out of five years.  The IRS has its eyes out looking for hobbies masquerading as businesses, and they’re likely to come knocking if they think you’re trying to pull one over on them.  Trying to disguise a hobby activity as a legitimate business is a no-no – don’t do it.  If the losses are normal for your type of business, or they’re due to circumstances beyond your control, read this to learn more on the criteria the IRS uses to judge whether or not you’re engaging in a business or a hobby.
  2. Consistently file or pay your taxes late.  This will trigger penalties and interest, as well as the IRS’ interest in your business.  The IRS’ mindset is to go where the money is, and they’ll see a greater opportunity for fines in a company that’s not managing its tax situation properly.
  3. Unreasonably low salary paid to shareholder who is also an employee of an S Corporation.  There are some out there who try to get around Social Security and Medicare taxes by receiving most of their compensation as a dividend distribution.  Be warned that the IRS takes notice of this.  Depending on their training, experience, duties, and responsibilities, the IRS may determine that their salary is too low, which will trigger a 100% penalty of whatever taxes they deem are truly owed.  A good rule of thumb is that if the shareholder has more responsibilities than the highest paid non-shareholder employee, his salary should be higher than the non-shareholder employee.
  4. Excessive deductions for business meals, travel, and entertainment.  Legitimate deductions are fine, but make sure you keep all receipts, document the attendees and the purpose, and keep detailed records of the expenses.  Also, make sure they would fall under the description of “necessary and ordinary;” i.e. a meal with a client at a nice local restaurant would be deductible, but flying them to Paris for the meal would not.
  5. Shifting income to tax-exempt organizations to avoid paying taxes.  This is considered a “listed transaction” by the IRS, and all participants must disclose their participation on their tax returns, including the charity or non-profit.
  6. Claiming 100% business use of a vehicle.  This one is a much larger red flag if that vehicle is the only one you own.  After all, if you use it 100% for business, how are you getting around the rest of the time?  Keep detailed mileage logs and records of your trips!
  7. You run a cash business.  There’s not much you can do to avoid this flag if the nature of your business requires mostly cash transactions (car wash, restaurant, etc.) – just be aware that these types of businesses are known by the IRS to have a tendency to under-report taxable income.  As always, keep detailed records of all transactions, and don’t be tempted to try to “sneak one by.”

As you can see, the IRS is mostly interested in ensuring they receive the tax they are legally owed.  Play fair, play smart, and play by the rules, and you’ll reduce the likelihood of receiving an audit notice.  And in the event you do get audited, you’ll be confident that you have the documentation and the legal standing to show you’re handling your tax situation properly.