The IRS may not scrutinize the majority of small businesses’ tax returns, but certain common mistakes can get auditors’ attention. Chances are that your business won’t be audited for review, as the IRS only audited 0.6% of individual tax returns in 2017. However, audits do still happen, so it’s best to avoid the many potential pitfalls that could catch an auditor’s eye.
Here are some of the biggest IRS audit red flags to watch for as a small business owner.
High Income Level
In short, the more money you make, the higher the audit rate. IRS reports show that in 2017, the rate for those with incomes of $200,000 to $1,000,000 without a Schedule C had a 0.8% audit rate, while individuals with a Schedule C attached had a rate of 1.6%. If your salary is over a million, this rate goes up to one in 23.
This isn’t to discourage you from making more, but it’s important to be aware that auditors will likely look closer at your returns as your income increases.
Neglecting to Report All Taxable Income
Regardless of whether you send them yourself, the IRS will always get copies of all W-2s and 1099s you receive, which means that you always need to report all taxable income on your returns. The computers the IRS uses are adept at matching all income appearing on your return with the numbers on each form.
Any type of mismatch can serve as a red flag and result in a bill sent back to you, which means you’ll want to make sure that every 1099 is accurate before sending it.
Taking Charitable Contributions
While charitable deductions can provide great write-offs, if they are considerably larger than your income, it could be a red flag for auditors.
This is because the IRS understands which amount of charitable donation is appropriate for individuals at your income level. To avoid any issues with charitable deductions, always file 8283 forms for noncash donations of over $500, and be prepared to hear from the IRS if you have donated any type of facade easement or conservation. Also, keep copies of all documents such as receipts for property and cash contributions.
Deducting Business Travel, Entertainment, and Meals
Large deductions on business meals and travel on Schedule C are likely to warrant an audit, especially if the amount appears too high for the business to easily afford.
If you want to qualify for meal deductions, maintain all records documenting the costs, along with the place, people in attendance, business purpose, and the overall nature of the meeting or discussion. It’s also important to keep receipts for expenses over $75 for any lodging when traveling away on business. Without this documentation, these expenses won’t be deducted. Auditors will also want to ensure that entertainment expenses such as golf outings and sporting event tickets are purchased explicitly for the purpose of client outings.
Failure to Report Foreign Bank Accounts
The IRS is deeply interested in individuals with money stored internationally, particularly if money is held in countries with notoriously low tax rates.
If you fail to report a foreign bank account, this could incur serious penalties, so make sure that you report any offshore accounts. This entails the filing of a FinCEN Report 114 (FBAR) by April 15 to report foreign accounts with a combined total of over $10,000 at any point throughout the previous year. If you have a lot more assets overseas, you may also need to include IRS Form 8938 with timely filed tax returns.
Taking all of these into consideration as a small business owner, you can take the proper steps to avoid issues if you are unexpectedly subjected to an audit.