With tax season nearing, let’s start with a bit of good news. The filing deadline for most people this year is Tuesday, April 18 instead of April 15 (the 15th is a Saturday, and the next weekday, April 17, is federal holiday Emancipation Day).
On a more serious note, the IRS is being closely watched as it begins deploying $80 billion in fresh funding approved by Congress, much of which was earmarked for stepped-up tax compliance and enforcement efforts.
Why the higher level of scrutiny?
According to a January 2023 TRAC report, over 164 million individual income tax returns were submitted to the IRS last year. Of those, only 626,204 returns were audited versus 659,003 in fiscal year 2021.
The probability of an audit last year for individual returns fell to 3.8 of every 1,000 returns filed, or 0.38%, whereas for fiscal year 2021, the probability of an audit was 0.41%.
Small business tax audits
As a small business owner, concern about making tax errors that unintentionally raise red flags to the IRS is pervasive. But data from the IRS suggest that about only 1% to 2% of small business owners face an audit.
IRS Commissioner Charles Retting wrote in a letter to lawmakers that the agency’s new funding was “absolutely not about increasing audit scrutiny on small businesses.” But with an expected 87,000 new agents to be hired and better systems, it’s reasonable to expect more audits and that small businesses will be affected.
Below we delve into the top 10 triggers for small business tax audits.
Failure to report income
Failure to declare income is one of the most common reasons for an IRS audit, whether intentional or by accident. Identifying a discrepancy between reported income and information provided on tax reporting forms is straightforward for the IRS, since the agency obtains copies of 1099s.
Additionally, the IRS is paying more attention to what individuals are earning through gig work and online sales. In 2024, the agency will require third-party settlement companies like PayPal and Venmo to provide 1099-K forms to individuals paid $600 or more through any of these platforms.
Your business is more likely to be audited if it’s heavily cash-based. The IRS states that it looks closely at cash-based businesses because of the propensity among some to neglect disclosure of cash income that should have been reported.
In general, audits are more likely to occur at businesses that rely on cash for profit and revenue, such as restaurants, laundromats, beauty salons, barbershops, taxi services and car washes.
You may also invite IRS scrutiny if your stated income is low but you make large cash transactions. Cash deposits to your bank account and other transactions totaling more than $10,000 may be reported to the IRS.
The IRS may also look askance at large cash sums on your Schedule C, particularly if you have a lot of cash expenditures.
An audit may result from expenses that are either inconsistent with IRS criteria for small businesses or that are much higher versus the previous year.
When it comes to the company credit card, certain expenses also tend to receive more scrutiny. For instance, claiming all of your meals throughout the working day as business expenses may look suspicious.
Large itemized deductions
Small businesses are expected to only claim itemized deductions that are appropriate, justified and entitled under tax laws. Claiming tax deductions for a sum much higher than than those with a similar profile can draw scrutiny.
Claiming a charitable deduction of $5,000 or more requires a qualified appraisal, and for every charitable donation, you must include Form 8283 with your tax return along with a receipt and appraisal, when applicable.
Losses reported on a Schedule C
As a small business owner, you must submit a Schedule C for individual tax filings in order to report business income. The Schedule C not only reveals your company’s earnings or losses, but it also places your return in the category of returns more likely to be audited.
It may seem tempting to make up a few expenses in order to maximize deductions and reduce your tax liability. But the IRS is on the lookout for reported losses that seem excessive, as the agency is well aware that small business owners may succumb to the urge to trim their tax bill.
Ensure you have documentation of your business’ annual revenue and expenses in case an audit occurs after you’ve declared losses.
Run a home-based business
You’re more likely to face greater scrutiny than other taxpayers if you claim expenses for a home-based business.
Your home office space must be solely used for business purposes, and no other activity should be conducted by either you or your family. If you intend to claim a deduction for a home office, IRS Publication 587 will help you figure out your expenses for business use of your home.
Shareholder-employees of S corps receiving low or no pay
Small business owners sometimes choose to form an S-corporation because it may offer preferable self-employment taxes compared to an LLC, since the owner can be treated as an employee and paid a reasonable salary.
The S Corp shareholder-employee should be paid according to what the IRS considers fair compensation, or a wage that is close to what other employers would pay for similar work, in order to gain from these tax benefits. If the business makes profits above and beyond pay, that can be shared as distributions.
The IRS is known to probe S corps that pay their shareholder-employees absurdly low wages, or no wages at all. Salary misalignment with respect to a position that is similar and in a similar industry, may warrant an audit.
An IRS business audit can be precipitated by suspicion of employee misclassification. Business owners may incorrectly designate workers as independent contractors rather than as employees to avoid paying for workers’ compensation, unemployment insurance, health insurance and certain taxes, among other things.
If you hire independent contractors, make sure you have documentation on the tasks they perform for your business.
When your books end in whole numbers, or in fives and zeros, it looks tidy and appealing. Of course it’s easier to calculate with multiples of five or 10, but the IRS is aware that such figures are simply not viable.
Rounding off your transactions (payments and expenses) or, worse, just estimating them, is a type of error the IRS watches for, so maintain your books accurately.
If your small business generates more than a million dollars annually, outsourcing your tax services to a professional is recommended, as your tax returns will likely be more complicated and subject to greater scrutiny by the IRS.
Some IRS audits are completely random, but most ensue from actions or omissions by the taxpayer. Reduce your chances of an audit by avoiding the triggers outlined in this article, and keep in mind that audits can usually be resolved by providing documentation that substantiates figures stated on your return. So hang on to your receipts and documentation, and keep your financial records accurate.
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