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Red Flags that Might Increase the Risk of a Small Business Audit

Every small business owner dreads the idea of being audited by the IRS. Even if you have a good bookkeeping and accounting system in place and you are careful to follow the guidelines set by the IRS, there is a chance that you might face a business audit at some point.

It is challenging enough to run a small business and manage cash flow. Adding the stress of an audit on top of your current responsibilities can feel overwhelming. Luckily, you don’t need to handle the situation without support. The most important thing that you can do is hire a good accounting team to help with the auditing process.

Preventing a Business Audit in the Future

There is nothing that you can do to eliminate the risk of an audit completely. But, you should be proactive to minimize the risk so that you can prevent the possibility in the future. As with many other aspects of life, prevention is more valuable than dealing with a problem after the fact.

Talk to your accountant for recommendations about things that you can do to lower your odds of an IRS audit. Certain actions might raise a few red flags, resulting in a situation where the government takes a closer look at your business practices and transactions.

Red Flag #1: You Aren’t Turning a Profit

If you are writing off business deductions, then you need to show that you are working to bring in a sustainable profit. Tax deductions aren’t designed to cover hobby activities. So, a trend of non-profitability could make the IRS suspicious.

Your accountant can help you determine the right strategy to avoid this red flag. As a general rule of thumb, you need to be profitable for at least two out of five years.

Just because your business isn’t profitable, doesn’t mean that you shouldn’t take the deductions that are available. Most accounting professionals will recommend that you maximize your deductions as much as possible to leverage the tax benefits that are available. But, you need to be sure that you are managing good records to document the transactions in case any questions arise.

One or two years of business losses won’t be enough to raise a red flag for the IRS. Instead, they are looking for a pattern of loss that might indicate unusual activity. The IRS wants to be sure that you are taking deductions for a viable business.

Also, consider a new business strategy and cash flow management if you are spending in the red every year. Your accounting team will help you find the right solutions to minimize overhead expenses and maximize the money that you are bringing in. Sometimes a few small adjustments can go a long way to improve your profitability.

Red Flag #2: Most Transactions are Cash-Based

There is nothing wrong with accepting cash payments. But, it could cause a red flag if every transaction happens with cash. We live in a digital world, which means that many businesses are moving towards credit card and digital transactions.

The IRS might scrutinize your company a little more if everything is done in cash. This method of doing business increases the likelihood that business owners or employees could be taking a little off the top tax-free. It’s easier to hide money or adjust the numbers if the transactions are handed over in cash.

It might be tempting to avoid some of your tax obligations by sheltering some of the money that comes in. But, it isn’t worth the risk that you will be facing for penalties and fines if you are audited. Protect yourself and your company by keeping careful records of your cash transactions and the way the money is flowing in and out of your business.

Red Flag #3: Failing to Report All Your Income

The digital age in which we live has made it possible for the IRS to scrutinize the transactions a little more than before. Remember that you aren’t the only one sending the IRS information about your income. Other businesses are required to submit tax forms and paperwork regarding the transactions and payments that were made.

For example, if you offer a services-based company and you worked as a contractor for another business, then that company will provide tax information about the amount of money that was paid to you in a calendar year. Then, the IRS has a computer system known as the “automated underreporter” that compares various types of income reports with the tax returns that are filed. This IRS computer ensures that the numbers match with things like mortgage interest costs, W2 wages, and 1099 freelance income.

So, if you receive income, then make sure that everything is reported on the forms and tax filing. It isn’t worth the risk of withholding some of the information. If the numbers don’t match up, then it could trigger an audit, which in turn increases the likelihood that you will pay back-taxes and additional money for fees.

Red Flag #4: Unusual Deduction Activity

Are you inflating deductions? Some business owners are looking for ways to maximize deductions, so they work the numbers when it comes to things like cash contributions, unreimbursed business expenses, medical expenses, and more.

You should always claim every deduction for the costs that are incurred for business-related activities and purchases. But, if your deductions seem out of line for your industry, or you are claiming a lot more compared to other people in the same income range, then it could be a cause for concern.

Red Flag #5: High Home Office Deduction

If you work from home, then you need to be specific about the amount of space that is being dedicated for business use. This calculation needs to be based on the overall square footage of your home, as well as the amount of space that is needed for the business activities.

In the situation where a business audit is completed, the IRS wants to see that the home office deduction is legitimate. Is that space only used for business activities? Or, is it a place where the business and personal activities are mixed?

As you are calculating your home office deduction, your accountant will also help you look at details for the other home-related expenses, such as utility costs, HOA fees, and more.

Red Flag #6: Using Cryptocurrencies

Cryptocurrencies are relatively new in the financial world. But, it doesn’t mean that you don’t need to report income that comes from these sources. If you have any transactions that are done using cryptocurrency, then the income always needs to be reported.

Failing to report your income from these currencies means that you could be facing prison time and as much as $250,000 in fines. The punishment varies depending on the situation. But, it’s always best to report the income so that you don’t face any of these fines or jail time.

Red Flag #7: Expensive Costs for Business Travel, Meals, and Entertainment

Expenses should be deducted when you are on the road for business. But, it will raise a red flag if you are writing off high costs for lavish restaurants, entertainment, and more.

If you are going to use these costs as deductions for your business efforts, then you need to make sure that you always have good documentation about why you needed to travel. At the same time, be reasonable with the frequency of the travel compared to the needs of the industry.

Of course, these details change depending on your business and ongoing activities. Just be smart about the way you are writing off the meals, transportation, and entertainment. Any time you have questions about legitimate write-offs, it is a good idea to talk to your accountant for custom recommendations.

Red Flag #8: Claiming Vehicle Use is 100% for Business Activities

It’s hard to prove that the vehicle was only used for business, because it is natural to use a car for personal activities as well. So, it isn’t a good move to write off 100% of the vehicle costs. Instead, keep a log in the car of the number of miles that were driven and the purpose of the trip. Then, you can take a standard deduction based on the mileage rate.

This tracking can be as simple as a notebook and pen in the car. Or, there are apps that are available now that make it simple to punch in the mileage numbers so that you can keep a digital log.

Enlisting the Help of an Experienced Accounting Team

Whether you are facing an IRS audit or you are being proactive to minimize the risk of an audit, you need to be sure that you have a trusted accounting team to help with your business finances. These services offer a valuable way to protect your company and minimize tax burden at the same time. Learn more by calling our experienced team at Easier Accounting. We specialize in small business accounting services and offer year-round bookkeeping, tax preparation, payroll processing, and more. Call today to learn more: (888) 620-0770