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7 Little Red Flags that Could Spark an IRS Audit

by Tracey Hrica Mar 27, 2023 | Share

The word “audit” is one of the things that scares business owners the most. 

So I’ve compiled a list of 7 red flags that could trigger an IRS audit to watch out for:

Big deductions for meals and travel

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. 

Always make sure you keep the receipt and itemize on the receipt who you met with and what you discussed. 

Although meals may be a deductible expense, the burden of proof is on you!

Mixing personal and business deductions

Save yourself the trouble and keep business separate from personal expenses to make record-keeping easier!

Keep a separate bank account and credit card for your business. 

In addition to removing a red flag, if you don’t separate them, it’s easy to overlook a business deduction or erroneously treat personal funds as business revenue.

Consecutive losses 

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.

When you have losses for three years in a row, you must be able to prove to the IRS that your activity is truly a business and not a hobby.  

A person that conducts an activity for profit can deduct the expenses that are ordinary and necessary in that industry. If the expenses exceed the income, a loss is incurred. This loss can offset other income, such as wages, interest, or dividends. 

However, if your activity is deemed a hobby for IRS purposes, you cannot reduce your wages, interest, or dividends by any losses. 

Misclassifying contractors

When you misclassify workers in your business, you are putting yourself at risk for unpaid taxes, penalties, and worse.

  • IRS may require employers to pay both their share and the employee’s share of FICA tax, as well as the employee’s portion of FUTA and income taxes.
  • Penalties may be assessed in the amount of 1.5% of the employee’s federal income tax liability plus a 20% penalty against the amount of FICA tax that should have been withheld.
  • Companies caught misclassifying workers may have to pay an additional penalty equal to 10% of the unpaid unemployment and disability insurance that was supposed to be withheld.
  • Companies can be charged with a misdemeanor that carries a $1,000 fine, a one-year jail sentence, or both.
  • Finally, the employee that was misclassified can also take legal action against the employer and seek up to three years of unpaid wages and penalties.

Underreporting income

The IRS uses an automated system (the Automated Underreported) to compare what you list on your return to reports they receive from other third parties. 

Information returns and schedules available to the IRS are extensive, including much more than just W-2 and 1099 forms. Once the taxpayer is matched to their Social Security number, the tax and information returns are compared to identify mistakes and potential omissions on the tax return.

If this system discovers a discrepancy, the IRS will issue a Notice CP2000 for you to correct the errors.

Not paying yourself a salary

If you are an owner of an S Corp, you need to pay yourself a salary within specific guidelines and report this salary on Form W-2.

When you form an S corporation, you’re no longer a simple business owner. Now, you’re the shareholder of an S corp, and you’ll also be your company’s employee.  

You must pay yourself wages for your work (a business expense). In addition, you and your company must pay Social Security and Medicare taxes on these wages. 

 Your business pays half as your employer, and you cover the other half through employee withholding. 

The IRS requires S corporation shareholder-employees to pay themselves REASONABLE SALARIES. 

 Reasonable is at least what other businesses pay employees for similar services. 

 If you fail to do so, the IRS can recharacterize all or part of your distribution as taxable employee wages. 

Excessive expenses

There is nothing wrong with claiming justifiable business deductions, and they’re an essential way for small business owners to reduce tax expenses. 

However, deductions not in line with what the IRS considers acceptable for your income bracket can attract attention.

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.

Bottom Line

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 end up on the wrong side and have to pay hefty penalties.

You can reduce your chances of being audited by looking out for these seven common red flags that can trigger an audit. 

Another way you can do that is by getting your books in order. 

Why take the risk of doing your own bookkeeping and potentially getting audited? 

Instead, 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? Schedule a call with us today.

About the Author

Tracey Hrica

Tracey Hrica joined the firm in 1995 as a bookkeeper. In 2012, she earned the designation of Enrolled Agent(EA), which enables her to prepare personal and business tax returns and represent clients before the IRS. To maintain the designation of EA, she must complete yearly continuing education in the areas of personal and business taxation. Working closely with her clients, Tracey’s primary areas of concentration are new client onboarding, client communication, research, and QuickBooks support. As a QuickBooks ProAdvisor, she works closely with clients who rely on QuickBooks for the day to day running of their business. Tracey has expertise in both QuickBooks Desktop and QuickBooks Online.

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