The IRS doesn’t reveal the exact details on how a small business tax return is selected for an audit any more than McDonald’s discusses the recipe for the Big Mac’s special sauce. The IRS does provides some hints here, but many point to red flags that scream “Audit Me” right into Uncle Sam’s ear.
Although the odds of facing a small business audit this year are less than one percent — based upon 2009 estimates — it’s still something best avoided from the start. Here are a few key areas of your return that can provoke a closer look by the feds — or at least raise Uncle Sam’s eyebrow.
- Hiring independent contractors who are employees - Trying to avoid paying payroll taxes, which includes income, social security, and Medicare taxes, on independent contractors who are really employees, is a big no-no, says the IRS. Misclassifying employees as independent contractors can result in taxes, penalties, and interest, not to mention triggering an IRS audit. While the IRS provides detail into these classification differences here, generally speaking, if you determine when and how your worker performs his work, the IRS will likely deem the person an employee.
- Hefty relative salaries - If someone works for you as a receptionist, but you pay her a VP salary, you may attract attention from the IRS. A special word of warning: If a family member works for your business, make sure that his compensation is comparable to what is being paid in the employment market. Check sources, such as PayScale.com or the Bureau of Labor Statistics, for salary estimates.
- Claiming a home office - While it’s rumored that claiming a home office may trigger an IRS audit, there’s no real proof of this. But whether urban legend or not, when it comes to being audited by the IRS, why take a chance? If you intend to write off a home office, be prepared to prove that you use it exclusively for your business and that it’s in a designated space in your home.
- Making a lot of cash – Your likelihood of an audit increases as your income level rises. While the chances of a small business being audited is less than one percent, if you’re a big fish (a large corporation with assets over $10 million) the odds of the IRS knocking on your storefront door rises to a whopping 15 percent. Obviously, that shouldn’t deter you from making as much money as you can — just keep good records!
- Reporting Schedule C losses - Passing off a hobby as a money-losing business will smell fishy to IRS examiners.
- Claiming luxurious business expenses - Unquestionably, claiming a 30-foot Sea Ray or Mercedes CL-Class Sedan as a business expenses probably won’t cut it. Even claiming a $5,000 desk when your reported business income is $40,000 is clearly unbalanced. Claiming large deductions that are disproportional to your business income may prompt the government to see if they can shake some more change from your business’s pockets.
- Being sloppy - Nothing triggers an IRS audit more quickly than errors. If supporting documents don’t match up or your return has math errors, as part of the taxman’s “Document Matching” process, it’s the quickest route to audit-land. Fortunately, math errors are down, thanks to better accountants — and good tax software.