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While most small business returns filed each year go unchecked, the IRS is definitely getting more active. For example, in November 2020, the IRS announced it would ramp up small business audits by 50% in 2021. Then, in August 2022, Congress passed the Inflation Reduction Actincluding $80 billion in IRS funding, of which about $45 billion goes toward enforcement — conducted by at least some of those 87,000 new agents the IRS is reportedly hiring.
So how can you stay out of the IRS’s sights? To some extent you can’t do anything as some audits are totally random. However, in most cases, audits are the result of taxpayer actions or omissions — some of which are more likely to result in junk mail from the IRS announcing an audit.
Here are five of the most common small business tax audit triggers.
Related: These are the top tax filing mistakes made by small business owners (and how to avoid them)
1. Failure to report income
Whether intentionally or simply because of a mistake, failure to report income is a common trigger for an IRS audit.
The IRS receives copies of 1099 forms mailed to your business, so in many cases it’s easy to spot a discrepancy between the reported income on a tax return and the information on tax return forms. If there is a discrepancy, the IRS will flag it on your return and most likely initiate an audit.
In addition, as more people turn to sideline activities and gigs to make money, the IRS is taking steps to ensure it monitors what people are making. While it has delayed execution for tax year 2022, the IRS will soon require third-party settlement organizations such as PayPal and Venmo to issue 1099-K forms to individuals paid $600 or more through these platforms.
Not reporting income? There is a good chance that the Tax and Customs Administration will notice.
2. Large deductions and excessive expenses
Small businesses must claim all justifiable business deductions. That is their right under our tax laws.
However, there are no clear-cut rules that define what is “justifiable” – just a somewhat vague standard that a business expense must be both ordinary and normal and necessary.
Because there is ambiguity about these terms, some taxpayers go too far and demand unreasonably high deductions and excessive expenses, leading to audits. The likelihood of a deduction leading to an audit increases if such deductions or expenses are inconsistent with IRS standards for peer companies and/or are significantly greater than the previous year.
It’s also important to note that certain deductions attract more attention than others, including the home office deduction, travel expenses, and vehicle usage, to name a few.
Related: Top Tax Write-offs That Could Get You in Trouble With the IRS
3. Large amounts of cash transactions
If you run a “cash business” such as a restaurant or barbershop, that fact alone makes you more likely to be monitored. When a company relies primarily on cash transactions, they face increased audit risk because the IRS may be concerned that the company is under-reporting income.
If your small business has a high volume of cash transactions, there may not be much you can do to avoid an audit, but keeping good records and disclosing your income will greatly reduce the risks associated with an audit.
4. Claim business losses year after year
Do you own a business or are you trying to write off expenses for a hobby? IRS guidelines say that if you have made a profit in at least three or five consecutive years, it is presumed that the business is being run to generate profit. Failure to do so could lead to an audit, as having several years of losses can lead the IRS to question whether you have a legit business.
In fact, if your business is not a hobby but continues to generate losses, make sure you keep accurate and comprehensive records to prevent your business from being classified as a hobby again.
It is common for small business owners to form an S Corp instead of an LLC to avoid paying self-employment tax on distributions. However, to take advantage of these tax breaks, the S Corp shareholder-employee must be paid what the IRS considers a “reasonable salary” — a salary comparable to what other employers would pay for similar services.
If there are additional profits in the company in addition to the salary, they can be paid as benefits.
The IRS is looking for S Corps paying shareholder-employees unreasonably low salaries — or in some cases no salaries at all. If the compensation is not properly aligned with a comparable position in a similar industry, this can lead to an audit.
Related: What I Learned From a Two-Year IRS Audit
What to do if you are audited by the Tax and Customs Administration
The idea of an audit instills fear in most people because it immediately conjures up a vision of IRS agents violently knocking on the front door of their home or business, ready to go through their records.
That’s not how things work, at least not for most people subject to audits. Remember that audits are rare. And when they do happen, most of them are done by mail. While not common, some audits take place at an IRS office (a “desk audit”) or at a home or business (a “field audit”). In any case, if you find out you’re being audited, don’t panic and contact an experienced tax attorney, especially if there’s a lot of money at stake. Do this right away, because the Tax and Customs Administration asks for a timely response.
In many cases, resolving an audit involves providing documentation to the IRS to back up the numbers on your return. That could end the case, or there could be an adjustment to the amount you owe, as well as penalties and interest, which you may have to pay.
However, you can disagree with the IRS’s conclusion, in which case you have 30 days to appeal the IRS’s findings. Litigation continues with an appeal to the IRS Office of Appeals, followed by a petition to the US Tax Court in the event your appeal is unsuccessful.
While it’s important to know what to do in the event of an audit, the best way to avoid negative consequences of an audit is to avoid one in the first place. Be aware of the most common audit triggers. Avoid them if possible. Keep good records. And if the IRS does call, contact an experienced audit attorney to help you through the process.