Why does the Internal Revenue Service audit some small businesses and leave others alone? Sometimes it’s a chance, but other financial practices, such as misreporting income, create audit triggers and trouble for small businesses.
Learn about six small business audit triggers and how to avoid them.
Misreporting Your Income
When you’re filing your taxes for the year, your Schedule C form will show your reported income. Incorrectly reporting your income creates audit triggers. This includes:
– Reporting a higher-than-average income
– Rounding up your income
– Averaging your income
– Not reporting all of your income
Disproportionate Deductions to Your Income
It’s not uncommon for small business owners to have itemized deductions on their tax reports. Some common tax deductions that business owners can claim include:
– Home office deduction
– Internet bills
– Travel costs
– Vehicle use
These tax deductions can change a business owner’s tax liability. But too many deductions raise red flags and create audit triggers for the IRS.
The IRS states that a legitimate business expense must be ordinary and necessary to qualify as a deduction.
– Ordinary expenses are common and accepted in your trade or business.
– Necessary expenses are helpful and appropriate for your trade or business.
Excessive Expenses
Spending a lot or drastically changing expenses from one year to the next can lead to an IRS audit. Although you may have a business credit card, transactions shouldn’t be excessive. For example, charging all of your meals during the workday as business expenses can raise red flags.
Large Amounts of Cash Transactions
Cash businesses are a type of business that brings mostly cash for profit and revenue. Examples of cash businesses include:
– Restaurants
– Beauty salons
– Barbershops
Since these businesses mostly rely on cash, they face an audit because the IRS may believe income is underreported. If your small business has a large number of cash transactions, it’s a good idea to be able to verify your income and document transactions regularly.
Claiming Business Losses Year After Year
If you claim a business loss each time you file your tax return, the IRS may audit you. While losses aren’t uncommon for a small business to experience, having multiple years of losses will leave the IRS questioning if you have a legitimate business.
Ensure you have documentation showing your business’ revenue and expenses throughout the year in case you get audited.
Misclassification of Employees
What triggers an IRS business audit may surprise you is that employee misclassification can be what triggers an IRS business audit. Business owners may misclassify employees as independent contractors for many reasons, such as:
– Lowering their business insurance costs
– Not having to pay certain small business taxes
– Reducing labor costs
The IRS defines an independent contractor as someone who controls what work will get done and how. The payer or business that hires the independent contractor can only dictate the result of the work. If you hire independent contractors, keep important documentation about their work for your business.
At Tax Time CPAs, we help small businesses focus on what they do best, providing the peace of mind of knowing they are financial protected. Call us for an appointment to learn more about how we can help.
This article was originally published by The Hartford and can be read here.