5 Red Flags That Increase the Chance of your Business Getting Audited
Dealing with taxes is a pain for any business owner. On top of the day-to-day running of your business, you need to track income and expenses, pay quarterly estimates, and drop everything to prepare your return when tax season rolls around. As if that weren't bad enough, there's the looming threat of learning the IRS selected your return for an audit.
The good news is that the IRS audits very few businesses each year. According to a recent report, less than one percent of the 196 million tax returns filed during 2016 were audited.
Still, nobody wants to be part of the unlucky few. That's why it's good to know about some red flags that could increase your chance of being audited.
Excessive business miles
If you use your personal vehicle for work, you can claim a deduction for business use. However, the IRS requires that you keep records detailing the number of miles driven, the time and place of travel, and the business purpose of your trip.
Business owners are often too busy to document their mileage properly. That's why deductions for business use of a personal vehicle are a prime target for auditors.
If you claim a reasonable number of miles and keep good records, you can rest easy. But excessive miles are a big red flag. So, what is reasonable? It depends on your line of business. Realtors and contractors driving from job to job spend a lot of time behind the wheel, so large mileage deductions are the norm. On the other hand, a business owner who spends most of their day in the office and tries to claim 100% of their miles are business-related can expect the IRS to take issue with their deduction.
When you prepare your return, you can round off numbers to the nearest dollar, but never to the nearest hundred or thousand.
Take a look at your Profit & Loss Statement. If you've been recording your expenses accurately, there are likely very few big round numbers. That's normal, and that's what you should report on your return. Otherwise, it's a signal to the IRS that you're estimating your expenses and not keeping adequate records to support your deductions. Just use an exact number.
Classifying employees as independent contractors
Do you hire people to work in your business? The people you hire may be independent contractors or employees, and there's an important legal distinction between the two.
IRS Publication 1779 gives some useful information on the difference between an employee and a contractor. Essentially, it comes down to the amount of control the business owner has over the person.
With an employee, you are required to withhold income tax, Social Security and Medicare from their wages. For an independent contractor, you don't have to withhold taxes. If you classify an employee as an independent contractor without a reasonable basis for doing so, expect the IRS to challenge that decision — and to and hold you liable for back employment taxes.
Large “miscellaneous" deductions
Your accounting software might have an account for “other" or "miscellaneous" expenses but try not to use it. Miscellaneous expenses are typically small, one-time expenditures that don't fit into another category.
Small amounts included in this account won't raise suspicion, but many large, routine transactions posted to this account signal to the IRS that you're padding expenses to avoid taxes.
Excessive business meals
Business owners are allowed a 50% deduction for meals while traveling on business or while entertaining clients. This area is prone to abuse, with people claiming a deduction every time they grab a cup of coffee or take their spouse out to dinner.
Claiming huge deductions for business meals is a big audit red flag. If you want to deduct your meals, follow the rules and keep good records including the amount spent, the time and place, and the business purpose of the meal.
Small business taxes are stressful enough without the added hassle of an audit. The tips above can't guarantee that you'll never get audited, but keeping impeccable records can ensure that if the IRS does come knocking, you won't lose all of the valuable tax deductions claimed on your return.