6 Reasons the IRS Will Audit You

An IRS audit is a review or examination of your records to ensure you file your taxes legally and accurately.

To reduce the difference between what the IRS is due and what the IRS obtains, or the “tax gap,” the IRS performs tax audits. Even though the IRS frequently chooses individuals based on suspected activities.

The audit rate is relatively high in the Hispanic counties of South Texas. Although it’s still unlikely, this may be changing. An IRS audit of your small business’s taxes is still unlikely.

Following a decade of fewer small company audits, the IRS said in 2020 that it would be stepping up its audit efforts in the future. The IRS may conduct an audit if you make certain errors on your tax return, such as omitting money or consistently declaring a loss.

6 Reasons for an IRS Audit

You should be aware of some “audit red flags” since they frequently prompt increased IRS inspection if you don’t use professional tax planning services. Here are a few typical small business tax audit initiation factors.

1. Increased large-scale cash transactions

Many ethical enterprises rely mainly or exclusively on cash for operations. Restaurants, independent contractors, and barbershops continue to utilize much money. But cash is trickier to trace than checks, PayPal, and credit card transactions.

Businesses with significant cash transactions are typically subject to IRS scrutiny. They have their own proprietary techniques for calculating the typical cash transactions in relation to other income you declare for various business kinds.

If you ever need to show the IRS that you are giving them the whole picture, you must have a complete record of every cash transaction. To disclose cash payments above $10,000, don’t forget to complete IRS Form 8300.

2. Filing a Schedule C for Continuous Business Losses

The main goal of a business is to turn a profit, and the IRS is concerned when businesses consistently record losses. When generating a loss is typical for the first year or two of operation, your chances of getting audited are reduced.

But the IRS could take a closer look if you only turn a profit two out of every five years. If your single proprietorship is more of a hobby than a business, they might want to look into that.

This is problematic since personal expenses for hobbies are not tax deductible, unlike company spending. They can also wonder if you’re fabricating your losses and using too many deductions to minimize your tax obligations.

Due to the blurry border between personal and company costs in these business structures, sole proprietorships typically attract greater IRS attention. If this is an issue, see your accountant about ways to keep the two distinct or even look into alternative business formats.

This does not imply that you shouldn’t make any reasonable deductions. To support such deductions in an audit, you must keep meticulous and watchful records.

3. Numerous Independent Contractors as Opposed to Employees

Contact the IRS if it finds that a company has misclassified its employees, resulting in States always looking for companies that use a lot of independent contractors.

Therefore, state tax officials frequently initiate this tax audit trigger rather than the IRS. Businesses that want to avoid paying state payroll taxes, such as unemployment and disability, sometimes recruit independent contractors rather than workers.

For these contractors, employers are also exempt from paying federal payroll taxes, including the employer’s share of Medicare and Social Security. This is a method of cost savings used by some companies.

But if such “independent contractors” are proper “workers,” things might go wrong. The state will frequently federal tax audits and any state fines. Both organizations are keen to ensure that payroll taxes are paid on time.

This does not preclude your company from using independent contractors, though; you must only make sure you adhere to state and IRS regulations regarding labor categorization. However, this can be difficult because there isn’t a single “worker status test.”

4. Excessive Expenses and Disproportionate Deductions

There is nothing wrong with taking legitimate business deductions, which is crucial for small business owners who want to lower their tax obligations. Deductions inconsistent with your business strategy or excessive compared to your revenue are primary reasons for a tax audit.

A significant rise in spending or deductions from the prior year will also likely draw attention. The “correct” number of deductions for each income category is determined by the IRS using various formulas and computations.

You may lower your risk by deducting expenses that are “ordinary and essential” for your line of business. IRS Publication 535 has further information on this and other company costs regulations.

Some deductions, such as home office, meal and travel, and vehicle deductions, are subject to more IRS scrutiny than others because they are often misused.

5. Stimulus Payments Related to the Pandemic

One of the motivations underlying the IRS’s intention to expand audit activities on small firms is pandemic relief. Expect increased scrutiny in the coming years if your company received loans or a boost from the epidemic measures.

Loans made possible by the CARES Act or Paycheck Protection Program were primarily meant to cover employee wages, rent, interest, and utility costs while firms were shut down.

After an audit, money that was misappropriated can become taxable income.

6. S-Corp Shareholders Employees Earning Low or No Salaries

Many small business owners choose to form an S-Corp rather than an LLC to avoid paying the 15.3% self-employment tax.

S-Corp shareholders who work as employees must be paid “reasonably” even if they are not liable to self-employment tax on payouts (reported as wages on a W-2).

The audit is frequently flagged on the individual tax return of a shareholder-employee, which prompts a corporate probe. The IRS keeps an eye out for S-Corps that pay shareholder-employees absurdly little (or even nil) compensation.

The IRS will compare your pay to the going rate for a comparable job in a comparable sector, so if you’re drastically overpaying, that’s a major red flag.

Make sure you have the documentation to back up your claims in the unusual event that you are audited. If you’ve been chosen for an IRS audit, you have the right to know why and the option to challenge any discrepancies as a taxpayer. You have the right to representation as well, whether it be from you or a designated representative.