It’s every taxpayer’s worst nightmare. You open the mailbox and find an envelope addressed to you from the IRS. You slowly open the letter and find your fears are confirmed; you are being audited by the internal revenue service.
An IRS audit can be expensive, time consuming and scary. And as a small business owner, you are among the most targeted group of taxpayers for audits. While it is impossible to make your tax return audit-proof, there are certain things that will greatly increase your chances of being audited. Here are seven red flags that may trigger an IRS audit.
- Claiming the Home Office Deduction: This is among the most abused deductions taken by small business owners. If you have an office in your home, you may qualify to deduct a portion of your mortgage/rent, utilities, real estate taxes, phone bills, insurance and even depreciate a portion of your house. These can add up to some pretty serious tax deductions. But be warned, the rules for taking these deductions are strict. In order for a space in your house to qualify for the home office deduction it must be used exclusively for business. This means the desk and computer you stick in your kids’ playroom or the spare bedroom probably doesn’t qualify. If you legitimately qualify for a home office deduction, it’s a great way to reduce your taxable income. But tread lightly; it’s one of the biggest audit red flags out there.
- Suspiciously Low Income- If you are reporting significantly less income than others in your profession, you are going to catch the IRS’s eye. This doesn’t mean you should report more income than you actually earned, but if you are claiming borderline deductions and it is bringing your income much lower than your industries average, you should think twice.
- Excessive Meals, Entertainment and Travel Deductions- One of the great parts about being a small business owner is the ability to write off meals, entertainment and travel expenses when business is involved. Excessively writing off expenses in these categories, however, is a giant red flag. One of the big keys here is the industry you work in. An insurance agent with significant meal and entertainment expenses may be explainable. A plumber with the same, not so much. If your business does not traditionally require wining and dining clients and prospective clients, be very cautious with the amount of expenses you claim in these categories.
- Running a Cash Business- Businesses that operate heavily in cash payments, such as taxis, car washes, bars, restaurants and hair salons are much more likely to be the target of an audit. The IRS is well aware of the fact that it is much easier to hide income as a cash business and they will target such businesses for audit as a result. While there isn’t much you can do to reduce your chances of an audit if you fall into this category, extensive records should be kept to protect yourself in the event an audit should occur.
- Large Income Variance From Prior Year- If you reported a $50,000 loss in 2011 and $200,000 of income in 2012, or vice versa, you may have some explaining to do. The IRS expects the income businesses report to be fairly consistent from year to year, and while you may have a perfectly legitimate reason for showing higher or lower income than the prior year, you better be ready to show them.
- Using Round Numbers- The odds that your mortgage interest came out to exactly $12,000, or your Meals and Entertainment expenses were exactly $3,500, is extremely unlikely. Using round numbers for any of your income or expense categories tells the IRS you are estimating your numbers. When they think you are estimating, they come looking for the exact amounts. You can avoid this with diligent record keeping and not needing to use estimates for your numbers.
- Claiming a Loss on the Business- Showing a loss on your business is one of the best ways to trigger an audit. If your business is losing money, the IRS starts to question the deductions you are taking. And if you show a loss in multiple years, your chances of being audited are even higher. This doesn’t mean the IRS expects your business to never operate at a loss, but it does mean you need to triple check the expenses you claim if you plan to show a loss.
While these seven red flags are capable of triggering an audit, it does not necessarily mean they should be avoided. All legitimate expenses you incur should always be taken. The point here is that if you fall into any of these categories you need to understand an audit is much more likely and you should prepare accordingly.
The increased risk of an audit is a small price to pay for being a business owner. By meticulously documenting and recording all of your income and expenses, and avoiding these seven red flags when necessary, you can both better defend yourself against an IRS audit and reduce your chances of being subject to one.
Question: Have you ever been through an audit? If so, what triggered it?