If I ask business owners what their least favorite part of running a business is, a lot of them will say taxes. And that’s completely normal. It wouldn’t even be too presumptuous to say that many business owners practically dread tax time. Even if you do everything right, you can’t completely push away the lingering fear that most small business owners carry: “What if I trigger an IRS audit?”

There is one thing that every business owner should understand: There is no way to be a hundred percent sure that you won’t get audited. Several of the audits that IRS conducts are completely random. Sometimes you can get audited simply because of your association with another taxpayer who is being audited. But in most cases, there are certain activities, mistakes, and suspicious patterns that can trigger an IRS audit, and that’s what I’ll discuss in this article. By covering all your bases, you can minimize your chances of being audited.

Common Audit Triggers and How to Avoid Them

Some businesses are inherently more in danger of being audited than others. Sole proprietors are more likely to be audited compared to corporations and partnerships. One of the primary reasons for this is that sole proprietorships are most likely to mix business and personal expenses. But there are some other factors as well. For a small business reporting no adjusted income, or an income of over $1 million, chances of an audit are higher than it is for businesses reporting an income in between. Similarly, small businesses earning over $5 million are even more likely to get audited.

There is nothing you can do about your business income (and you shouldn’t. Make as much money as you can, legally). But there are other triggers that you can avoid.

Incomplete Reporting

To be fair, nobody underreports their taxes on purpose. There are several unintentional ways of attracting the wrath of the IRS, other than poking the proverbial bear with intention. Failing to report part of your income is one way you trigger an IRS audit. Many cash-heavy businesses sometimes miss reporting income from a one-time client, who didn’t issue them a 1099-MISC for a particular job. Similarly, when businesses earn income for jobs/services that are out of their SOPs (standard operating procedures) or usual practices, they sometimes fail to report them on their tax forms.

As we move faster and faster towards digitization and connectivity, it’s getting easier for the IRS to reconcile your tax numbers from other sources. Let’s say you usually get paid via bank transfers, but some clients pay you using PayPal. If you miss or fail to report the latter on your tax returns, and the IRS compares it to the data it receives from PayPal, it’s an automatic trigger.

Another thing along the same vein is that you don’t use averages when filing your taxes. Be as accurate as possible. Ideally, you shouldn’t even round off your numbers on your taxes.

Back-to-Back Business Losses

IRS notices if you claim business losses year after year after year. If you are not profitable, why are you sticking with the business in the first place? That’s something even a normal person would ask if you tell them that you are running a business where you are spending more than you are making. The IRS sees it as a ploy to pay less in taxes.

Ironically, some businesses don’t even realize that they are incurring losses instead of making a profit until it’s time to do their taxes. While some businesses just take more time to gain traction, a first few profit-less years are a norm for them. But the IRS might think that you are overinflating your losses in order to lower your tax obligations. And they probably will audit you to get to the bottom of the situation.

There are a few outcomes in this scenario. One is that the IRS finds your tax deductions unjustified. If you claim too many business expenses, it can push legitimate profits into loss territory, thus saving you in taxes. Secondly, the IRS might label your business as a hobby if they think that your motive isn’t to make a profit, and you are claiming your hobby expenses as business losses to lower your taxable income (which is illegal).

This is a tricky area, as even in a legitimate business, it’s possible to experience a few bad years. So even if you do trigger an IRS audit, make sure all your records and documents are in order, so you can prove that your losses are legit.

The Home-Office Trap

Many sole proprietors run their business from home. It’s smart. You don’t have to waste resources on additional space and utilities. Plus, you can claim home office tax deductions. But this is where many people go overboard. The IRS dictates that you can only claim the portion (specific square footage) of your home that you use exclusively as your home-office. If it’s a flex-use area (used as both a portion of the home and your office), then you can’t claim any deductions on it.

There are two methods to deduct your home-office expenses. One is a recently introduced simplified method, where you can deduct $5 per square foot (up to 300 square feet) a year for your home office. If you opt for this method, your total tax-deduction cannot exceed $1,500 a year in home office expenses.

Then there is the regular method, where you calculate the actual square footage of your home office. Then you compare it to the total area of the home and figure out what percentage of your home is your office. This ratio is used to calculate your actual home-office expenses, i.e., mortgage/rent, utilities, insurance, depreciation, etc. Even with this method, if your numbers don’t actually jump out as suspicious, you might be safe.

Unfair Deductions

Business meals and vehicle use for business are two legitimate deductions, but only within fair reason. Previously, entertainment was a part of these deductible business expenses, which allowed business owners to take their clients for vacations as tax-deductible expenses. Following the Tax Cuts and Jobs Act (TCJA) changes, it’s not anymore.

Take business meals, for example. Many people believe that just to have a receipt for the restaurant where they held a business meeting or met with a client is enough. It’s not. You should have a record of who you met with, what you talked about, or if any business transaction took place. This information augments the credibility of your claim that it was indeed a business meal, and you can justifiably deduct it as a business expense.

The same is the case with the vehicle. Many business owners fail to split the vehicle used for business and personal use carefully. Like the home office, you have two options for it. You can use the simplified method and deduct 57.5 cents per mile, based on your business mileage.  Or you can use the actual method, and keep meticulous records of your mileage, and your vehicle’s business use. It could get a bit difficult if you dropped your family to the store when you went to meet a client.

In any case, any improper business deduction can get you flagged for an audit. It also includes disproportionate deductions i.e., any deductions that you claim, which do not reconcile with your business income and usual expenses.

Employment Taxes

Employee taxes are usually a problematic topic for small business owners who are used to doing things on their own. When a business brings in employees, the owner should become familiar with all the employment tax rules.  For example, in addition to withholding FICA, Medicare, and other taxes from the wages of an employee, the business owner will have to pay the employer’s share of these taxes as well (like 7.65% in 2020 for FICA).

Ironically, while many employers are prompt about withholding these taxes from monthly wages, they aren’t so much on top of depositing them in a separate bank account. Then, when it comes to paying taxes, they have to arrange substantial sums just to take care of these tax liabilities.

Other Things that Can Trigger an IRS Audit

There are a few other things that can add to the probability of a small business being audited.

  • Cash heavy businesses (like restaurants) are usually audited more. But that’s quickly changing as we are moving towards a cashless future.
  • Filing amended returns often can increase your chances of being audited.
  • Your numbers should always be accurate. If there are basic math errors on your returns, and your numbers are not adding up, your returns can get flagged.
  • Excessive charity, while a good thing for the soul, is not so good for your chances of getting audited.
  • If there are any anomalies in your business expenses, expansions, or acquisitions, you should be thorough about reporting them. If IRS finds your tax returns breaking pattern from your previous returns, it can decide to audit you.

Conclusion

As you can probably see from this list, keeping a meticulous record of every business transaction is very important for accurate taxes and steering clear of an audit. Another thing that can help you out is using the right software. Manual record keeping is a thing of the past. Also, manual tax filings are over 40% more likely to contain errors, compared to e-filing.

If you want to do it all yourself, i.e., bookkeeping, accounting, and taxes; do your research and make sure you are well-versed enough to get your books and taxes right. If you are unsure, you might want to outsource these important tasks.