Why does the Internal Revenue Service audit some small businesses and leave others alone? Are there things that business owners do that can be small business tax audit triggers? Sometimes it’s chance, but often, certain financial practices can lead to a small business IRS audit.
Learn about six small business audit triggers and how you can try to reduce your chances of getting audited.
1. Misreporting Your Income
When you’re filing your taxes for the year, your Schedule C form will show your reported income. If you incorrectly report your income, it can increase your chance of being audited. This includes:
- Reporting a higher-than-average income
- Rounding up your income
- Averaging your income
- Not reporting all of your income
2. 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 may be able to claim include:
- Home office deduction
- Internet bills
- Travel costs
- Vehicle use
These tax deductions can change a business owner’s tax liability. But if you have too many deductions, it can raise red flags and trigger an audit from the IRS.
The IRS states that a legitimate business expense has to be both ordinary and necessary to qualify as a deduction.1
- Ordinary expenses are common and accepted in your trade or business.
- Necessary expenses are helpful and appropriate for your trade or business.
3. 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.
4. Large Amounts of Cash Transactions
Cash businesses are a type of business that bring mostly cash for profit and revenue. Examples of cash businesses include:
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 amount of cash transactions, it’s a good idea to be able to verify your income and document transactions regularly.
5. 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 can lead to the IRS questioning if you have a legitimate business.
If your business gets audited and you claimed losses, make sure you have documentation to show your business’ revenue and expenses throughout the year.
6. Misclassification of Employees
It may surprise you 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 a person who controls what work will get done and how.2 The payer, or business that hires the independent contractor, can only dictate the result of the work.3
If you hire independent contractors, keep important documentation about the work they’re doing for your business.
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As an expert in small business taxation and IRS audits, my extensive knowledge in the field allows me to provide insights into the factors that may trigger IRS audits for small businesses. It's crucial to understand that the Internal Revenue Service (IRS) conducts audits based on various criteria, and certain financial practices can increase the likelihood of an audit.
1. Misreporting Your Income: Small business owners should meticulously report their income on the Schedule C form during tax filing. Any deviation from accuracy, such as reporting a higher-than-average income, rounding up income, or averaging income incorrectly, can raise red flags and lead to an audit.
2. Disproportionate Deductions to Your Income: While legitimate business expenses can be claimed as deductions, excessive or disproportionate deductions in relation to income can attract IRS attention. Business owners should ensure that their deductions are both ordinary and necessary for their trade or business, as per IRS guidelines.
3. Excessive Expenses: Drastic changes in expenses from one year to the next or spending excessively, especially without proper documentation, may trigger an IRS audit. Business owners should maintain transparency in their financial transactions and ensure that expenses align with the ordinary and necessary criteria.
4. Large Amounts of Cash Transactions: Businesses that predominantly deal in cash, such as restaurants, beauty salons, and barbershops, are susceptible to audits due to the potential underreporting of income. Regular documentation and verification of cash transactions are essential to demonstrate the accuracy of reported income.
5. Claiming Business Losses Year After Year: While it's common for small businesses to experience losses, consistently claiming losses over multiple years could lead to IRS scrutiny. Business owners should maintain thorough documentation of business revenue and expenses to substantiate the legitimacy of claimed losses.
6. Misclassification of Employees: Misclassifying employees as independent contractors for financial gain, such as lowering insurance costs or avoiding certain taxes, can trigger an IRS audit. Business owners should adhere to the IRS definition of an independent contractor and maintain proper documentation regarding the nature of the work performed by individuals in their employ.
In conclusion, understanding and adhering to proper financial practices, accurately reporting income, maintaining transparent records, and ensuring compliance with IRS guidelines can significantly reduce the chances of a small business being audited. By following these recommendations, business owners can navigate the complex landscape of small business taxation and minimize the risk of IRS scrutiny.
