The possibility of an IRS audit haunts many businesses, but what factors contribute to that risk? For example, have business processes been implemented to sufficiently capture required documentation, such as withholdings and withholding taxes? Has the business been consistent with its accounting methods?
Large corporations are the most frequent targets for audits, but other entities such as sole proprietors with $1 million or more in income also come under close IRS scrutiny. Smaller corporations, partnerships and smaller sole proprietors may be less likely to face an audit, but missteps can increase the likelihood.
What Can Trigger an Audit?
A business tax return can be flagged for an audit for several reasons:
- High meal and entertainment deductions: The IRS tracks the typical level of these expenses for each business category, and a red flag will be raised if meal and entertainment expenses are deemed excessive. Failure to provide sufficient documentation, such as the names of people in attendance and the business reason for the meal or activity, can cause the expenses to be disallowed.
- Big changes in year-to-year income or expenses: The IRS looks for anomalies and any dramatic shift in income or expenses can trigger an audit. While a swing in numbers can have legitimate business reasons, a business must be prepared to document it.
- Claiming business losses over several years: The IRS expects that start-up businesses may not show a profit for a few years. However, if a business consistently claims a loss for several years, the IRS will likely investigate whether deductions are valid and if the business is a viable venture as opposed to a hobby.
- Running a cash-based business: The IRS has found that cash-based business owners tend to overlook income that should be reported. As a result, businesses such as restaurants, convenience stores, hair salons, car washes and laundromats are at higher risk for an audit.
- State sales and use taxes: More states are auditing sales and use tax filings and in the wake of the South Dakota v. Wayfair decision, they are going after internet companies to collect sales tax. Failure to report and pay state sales and use taxes can trigger the states to report such discrepancies to the IRS.
- Independent contractors on your payroll: Classifying workers as independent contractors rather than employees saves on payroll taxes and benefits. However, having a large number of independent contractors can flag a state audit. If the state finds that workers are misclassified, it will notify the IRS and this often results in an audit.
- Math errors and rounding numbers: Lack of attention to detail can result in reporting errors. If documentation is lacking for some items, there may be a temptation to “guesstimate” and list rounded numbers. The IRS knows this and it looks particularly for income and expense items that are rounded in multiples of $100.
- Failing to file or submitting incomplete returns: All businesses are required to file tax returns, even those reporting a loss. If a business does not file for a few years and then files once again, the IRS will want to know why. Similarly, providing incomplete returns will provoke questions by the IRS.