Updated: October 22, 2018
The thought of being audited by the IRS can strike fear in even the most stout-hearted taxpayers. According to IRS Commissioner John A. Koskinen, 1.2 million individuals were audited in the fiscal year 2014. Let’s look at some of the common IRS audit red flags so you and your business can avoid them.
5 major IRS audit red flags to avoid
Underreporting income
Business owners often receive income from diverse clients and through diverse payment forms. This administrative overhead makes it easy for them to underreport income and generate IRS audit red flags when that income is suspiciously low compared to the average for their type of enterprise.
Businesses that rely largely on a cash payment model should be particularly vigilant in ensuring that both cash and tips are properly accounted for. Leveraging a systematic method of tracking accounts payable and accounts receivable can help you accurately assess your taxable income.
Overreporting business expenses
Expenses that are considered “ordinary and necessary” for business use can be deducted. However, the IRS already has a notion of what defines ordinary and necessary for your specific trade or business. For example, travel or entertainment expenses that significantly exceed the statistical norms for other enterprises like yours can generate IRS audit red flags. You can avoid a tax audit by keeping scrupulous, timely records and deducting expenses only for the percentage of business use.
Claiming substantial business losses
Incurring a business loss can be catastrophic. Fortunately, net operating losses can be deducted to reduce or even eliminate your tax liability. However, the IRS inspects such claims more closely to ensure that business owners are not simply evading a larger tax bill or reporting a loss incurred from a hobby in the guise of a business loss. Losses incurred from a hobby, as opposed to a business venture, are not deductible.
Misclassifying workers
For tax reporting purposes, classifying a worker as an independent contractor enables a business to avoid paying payroll taxes and keep more cash in circulation. However, the classification of your workers must reflect the de facto status of the workers. If Joe employs ten workers and classifies all of them as independent contractors, he might raise IRS audit red flags and be asked to prove his workers’ status.
Claiming big-ticket deductions
Claiming substantial deductions—such as for home office use or frequent business vehicular use—can make you more prone to scrutiny by the IRS. Especially, if the deductions on your return are disproportionately large compared with your income. This mismatch may bring the IRS to pull your return for a review.
However, maintaining discretion and compliant documentation enables you to take even the most daring deductions and still avoid a tax audit. A mileage tracking app like MileIQ can take the wheel of your mileage reporting and give you the confidence you need to claim the mileage deduction you deserve.
Claiming excessive charitable deductions
Understandably, charitable contributions are a great write-off and help you feel all warm and fuzzy inside. Nevertheless, if your charitable deductions are disproportionately large compared with your income, it raises a red flag.
Why? Because the IRS knows what the average charitable donation is for folks at your income level. Also, if you don’t get an appraisal for donations of valuable property, or if you fail to file Form 8283 for noncash donations over $500, you become an even bigger audit target. Be sure to keep all of your supporting documents, including receipts for cash and property contributions made during the year.