So, have you ever wondered what becomes a “Red Flag” for the IRS when they process your tax return? I believe we all agree, an IRS audit is among the very last things we ever want to experience. Of course, having your taxes completed by a reputable, knowledgeable tax preparer means that these Red Flags will be caught BEFORE your return is filed with the IRS. It’s all in the information and maintaining the supporting documentation. Here are some of the most common Business and Personal Red Flags:
Red Flags for Your Business Tax Return
Business or Personal Expenses?
Are you sure each expense is truly a business expense…or is it personal? Particularly with family operated and home-based businesses, this line can sometimes become blurred. Keeping your personal and business expenses meticulously separated and well documented is 90% of the battle in avoiding this Red Flag. Make sure to have a separate bank account for your business. The IRS gives us a definition for deductible business expenses. The expense must be ordinary and necessary. “An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.” If unsure, you can always give us a call.
Car Mileage / Vehicle Expenses
First and foremost – whether you use your vehicle 100% for business or any blend of business and personal – you want to be sure to keep a detailed (daily) mileage log. The IRS regularly requests to review mileage logs during audits and reviews. If your vehicle is used at times for personal use, you can either deduct the business usage using the Standard Mileage Rate or the Actual Expense Method. Reading the IRS code on this topic can be very confusing, so again, this is where a knowledgeable tax preparer comes in handy. Other car expenses for parking fees and tolls attributable to business use are separately deductible, whether you use the standard mileage rate or actual expenses.
W-2 vs. 1099
We’ve shared with you before the importance of correctly identifying those who do work for you as either employees or independent contractors. The determination can be complex, but is based on whether the person for whom the services are performed has the right to control how the worker performs the services. It is not based merely on how the worker is paid, how often they are paid, or whether they work part-time or full-time.
There are three basic categories of factors that are relevant to determining a worker’s classification:
- Behavioral control
- Financial control
- Relationship of the parties
Amounts paid to outside providers for services such as bookkeeping, accounting, and tax services are tax deductible. You can read more on this through the following link. https://www.centuryaccounting1.com/2019/12/17/independent-contractor-or-employee-heres-what-you-need-to-know-about-worker-classification/
Capital Expenses/Depreciation Versus Deductible Expenses
Typically, the purchase of new equipment, property, building, etc. and anything that increases the value of the asset, appreciably lengthens the time you can use it, or adapts it to a different use is a Capital Expense and the expense is recovered over time – aka depreciation. Some examples are a new piece of machinery, a service vehicle, new electric wiring of the business property, new plumbing, or bricking up windows to strengthen a wall.
Repairs and Maintenance Expenses such as “wear and tear” maintenance on company cars, short-lived machinery parts, tools with life expectancy less than 1 year or of minimal cost, sealing an existing driveway/parking lot, etc. are deductible in the tax year in which they are incurred. You do need to be cautious here in that your Repairs & Maintenance Expenses are not categorized as “excessive” when compared to the revenue of the business.
Travel and Meals Expenses
As a business owner, beware that now, more than ever this is a big Red Flag area for the IRS. We frequently hear business owners say, “I’ll just write that meal off as a business expense.” A word to the wise – make sure you keep the receipt of the meal, and itemize on the receipt who you met with, and what you discussed. Although it may be a deductible expense, the burden of proof is on you! In documenting these expenses, the IRS will look for the following 5 pieces of information for each expense:
- The Date – the date on which the expense was incurred
- The Amount – the total amount including tax and tip
- The Place – the business/restaurant name and location where the expense was incurred
- The Business Purpose – for example, to obtain future business, encourage existing business relationships, etc.
- The Business Relationship – the business relationship of the people/event involved, such as list of their names and occupations and other information to establish their business.
For S-Corp Businesses – Dividend Payments to Shareholders
When a shareholder-employee of an S corporation provides services to the S corporation, reasonable compensation generally needs to be paid. This compensation is subject to employment taxes. Revenue Ruling 74-44 states that the IRS will re-characterize small business corporation dividends paid to shareholders as salary when such dividends are paid to the shareholders in lieu of reasonable compensation for services. You can also read more here: https://www.centuryaccounting1.com/2020/01/27/all-eyes-are-on-s-corporations/
Any Expenses Appearing “Excessive”
Each area of deductions has various limitations, contingencies, exceptions, etc. and are frequently compared against other factors such as revenue and may be determined as “excessive”. Any deductions that are seen as “excessive” will absolutely have the IRS waiving their Red Flag and requesting additional information and/or lead to an audit.
One category on your income statement that should not have a lot of expenses in it is the “catch all” of Miscellaneous Expenses. Every attempt should be made to categorize your expenses in something other than “Miscellaneous”. Excessive uncategorized expenses could lead to scrutiny.
Red Flags for Your Personal Tax Return
- Mortgage Interest – the IRS will look at your affordability in paying the reported amount of interest based on your reported income. While many people in the last several years have experienced reduction in income levels and may still have the same mortgage, there is a point where the IRS will question, based on income, how the seemingly unaffordable interest is getting paid and whether there is unreported income.
- Charitable Donations – here again they will consider the level of income and may question the total charitable donations. You will want to be sure, especially if a large item is donated, to obtain a receipt from the receiving organization documenting the value of the item donated.
- Interest & Dividend Income – there are a lot of tax documents that hit your mailbox each January/February and it can be easy to miss these 1099’s. It is recommended that you make a list of the institutions that you receive interest income/dividends from so that when you gather all of your tax preparation documents, you are able to account for all of the 1099’s that have been reported to the IRS.
- Filing Status & Exemptions – you may be surprised at how many people file using the wrong filing status (single, married filing jointly, married filing separately, head of household). The regulations are very specific and filing using an incorrect status or number of exemptions/dependents can quite adversely affect your liability and you could incur additional fees and penalties. Separated/divorced couples cannot both claim the same dependents – a dependent may only be represented on one tax return each year.
Be sure your personal and business taxes, if they are not already, are being prepared by Century Accounting. We help keep you out of the Red Flag Zone!