7 Red Flags That Could Get Your Small Business Audited

What are the red flags the IRS looks for before it audits your business? And if they come knocking, what should you do?
February 21, 2014

As a small-business owner responsible for overseeing every aspect of your business, you are most likely pressed for time, which means that even the thought of an audit can cause your heart to skip a beat. We recently asked the OPEN Forum community: When it comes to taxes and audits, what are some of the red flags for small businesses? Have you been audited, and what was the experience like?

While there’s no guarantee that you can prevent an audit, there are tactics to make the prospect less likely and things you should and shouldn't do if the "tax man" does come knocking on your door.

Guilty Until Proven Innocent

An audit involves a thorough review of income and expenses for your business, and it’s important to realize that the burden is on you to answer the IRS’s questions and prove you made the amount of money you reported and are due certain deductions.

“The IRS is looking for income that might be unreported, under-reported or deductions that might be overstated,” says OPEN Forum community member Sazeeda Itwaru, a business consultant who is principal of Avant-Garde Consulting, a tax advisory and business consulting practice.

It’s your obligation to pull out and provide all the documentation requested by the IRS—and the excuses that you didn’t know or your dog ate your paperwork won’t cut it.

Red Flags to Avoid

There’s no surefire way to avoid a tax probe, but according to Itwaru, small businesses can cut the chances of being audited by avoiding the following red flags.

1. Reporting a net loss in more than two out of five years. “If the business cannot satisfy three years of profits in a five-year period, you are likely to get audited, so it’s advisable to follow the IRS publication 535 guide for business expenses,” Itwaru says.

2. Consistent late filing of tax returns and payment of taxes. Failing to follow filing requirements and meet deadlines triggers penalties, interest and unwanted attention. Always ask for an extension if you won’t be able to meet a deadline.

3. Unreasonably high salaries paid to shareholders who are also employees. Determine reasonable salaries for your type of business based on industry, skill level and geographic location.

4. Excessive deductions for business meals, travel and entertainment. Maintain receipts for all expenses, along with detailed records, and don’t overstate these expenses.

5. Shifting income to tax-exempt organizations such as charities to avoid paying taxes. This is considered tax abuse.

6. Claiming 100 percent business use of a vehicle. “If the vehicle is not designated for business use and there is not another vehicle available for personal use, the business owner should maintain detailed mileage logs and calendar entries for the purposes of each trip,” Itwaru says.

7. Cash businesses beware. Cash-intensive businesses, such as beauty salons, restaurants and car washes, will always be under closer IRS scrutiny, as they are more likely to under-report taxable income.

What to Do if You're Audited

OPEN Forum community member Betty Pelzer-Sharper, who owns the Washington, DC-based residential real estate brokerage BSharper Real Estate, was involved in a random audit. “It was my first year filing as a new business with a lot of expenses," she says. "The audit was time-consuming and stressful, but I got though it without having to write a check.”

Pelzer-Sharper fared well in terms of the outcome of her audit because she called her CPA. She also had an ultra-organized system for maintaining and retrieving key tax records like receipts and expense and income documentation.

“I maintain a database on my expenses and income, and my filing system is categorized like my expenses and income on my tax return,” she says. “This enabled me to reconcile my expenses and income against the data in my database and my receipts and documentation. My American Express Year-End Summary report was a great resource as well.” With her CPA’s assistance, Pelzer-Sharper also provided the IRS with a detailed cover letter that outlined what documentation she included in their requested package.

In addition to good records, Pelzer-Sharper made sure to have positive interactions with the IRS agent. “A bad attitude will hurt you,” she says. Be polite and do your best to meet the deadlines set forth by the agent or ask for an extension.

Never Ignore Tax Notices

Even if you don’t have the money to pay the government, don’t ignore tax notices, warns Itwaru, who was audited a few years ago and feels that one of the reasons she fared so well was that she responded to her audit notice in a timely manner.

“Ignoring tax notices won't make the problem go away, it will only make it worse,” Itwaru says. “Penalties and interest start to build up, and over time, the IRS can levy, lien or seize your property!”

In other words, always address the tax man head on.

Read more articles on small-business taxes.

Photo: Cassandra Hubbart