Avoiding audits is a top priority for business owners, who are well aware of common tax audit triggers like mixing personal and business finances or deducting expenses without proper documentation. These preventive measures largely rely on common sense. However, audits still catch many businesses off guard each year, resulting in wasted time and money. So, where do these businesses go wrong?
Here are ten lesser-known tax audit triggers that every business should be aware of, along with suggestions on how to avoid them.
1. Excessive use of contractors:
Classifying workers as contractors instead of employees might seem appealing for easing the burden of payroll taxes. However, the IRS closely scrutinizes businesses suspected of mislabeling workers. Companies with a high number of contractors are particularly targeted. It is crucial to ensure that your business properly classifies its workers.
2. Vague “miscellaneous” deductions:
To minimize the risk of an audit, it’s important to avoid claiming an excessive number of deductions categorized as “miscellaneous” or “other” under Schedule A. Instead, itemize your expenses in the relevant categories specified in Schedule C. If you have unique deductions, clearly explain them to avoid confusion.
3. Exorbitant executive compensation:
The IRS pays close attention to high-income earners and shareholder-employees in C corporations due to the impact of high salaries on a company’s overall income and tax liability. Educate yourself on how to prevent scrutiny for “unreasonable compensation.”
4. Inconsistent social media presence:
Believe it or not, auditors sometimes scour social media to verify tax claims, especially when suspiciously high deductions are involved. While social media may not be a direct audit trigger, it can become a valuable tool for the IRS once discrepancies are identified.
Be cautious about sharing photos on platforms like Facebook, Instagram, and Twitter that may give the impression of a leisure trip rather than a professional one when deducting business travel expenses.
5. Family members on the payroll:
Hiring family members is common, but the IRS wants to ensure it’s not a strategy for extracting more money from the business or evading taxes on gifts. If you employ family members, make sure they work the designated hours, have appropriate qualifications, and actively contribute to their positions.
6. Reporting net income instead of gross revenue:
Many business owners unintentionally report the net income on Schedule C (Form 1040) rather than the gross income from sales. For instance, if you receive an Amazon Payment for a product sale with the processing fee already deducted, report the gross income (the pre-deduction total) in Part I and list the processing fee as an expense in Part II.
7. Overclaiming home office deductions:
While the IRS has relaxed its stance on home office deductions to some extent, claiming substantial deductions compared to your business income still raises eyebrows. Exercise caution if you claim:
- Both a home office and a rented office space.
- Over 50% of your home as a dedicated office.
- A significant amount for home maintenance and utilities.
8. Missing tax-related deadlines:
It should be self-evident, but failing to meet IRS deadlines suggests inconsistency and increases the likelihood of an audit. This applies not only to annual tax returns but also to other crucial deadlines like quarterly estimated tax payments.
9. Incorrect accounting method:
Businesses typically use either cash accounting or accrual accounting methods. While most companies can use the accrual method, not all are suitable for cash accounting. Understand the difference between the two and ensure you are using the appropriate method before filing.
10. Self-employed travel and entertainment expenses:
Being self-employed or a sole proprietor makes you a prime target for the IRS. Deducting expenses like meals, flights, hotels, and entertainment requires strict adherence to substantiation rules. Merely keeping receipts may not suffice; maintain detailed records including the location, attendees, and purpose of each gathering.
The Final Step
To minimize the risk of triggering a tax audit, e-filing is highly recommended. Online tax software significantly reduces the chances of errors or inconsistencies, as the system automatically checks your numbers before submission. Tax software can identify potential red flags and estimate your audit likelihood, allowing you to address any concerns prior to filing. E-filing also eliminates the risk of being flagged for illegible or unclear handwriting.
For particularly complex tax situations, consider conducting a risk assessment with an accountant. If you are at a high risk of an audit, a professional tax preparer can suggest strategies to lower your odds, granting you peace of mind when April approaches.
Remember, staying informed about lesser-known tax audit triggers and taking proactive measures to avoid them can save your business valuable time and resources while maintaining compliance with tax regulations.