Statistically, any single small business is unlikely to be audited by the Internal Revenue Service (IRS), but the threat is not to be taken lightly. The good news is there are steps you can take to avoid the IRS scrutiny. If you understand that certain accounting mistakes lead to red flags, your business can avoid the costly auditing process and associated penalties.
Here are the top five accounting red flags that can put you on the IRS’s radar (and some tips to help you avoid them):
- Don’t take unusually high deductions.
- Report all your income.
- Avoid excessive cash transactions.
- Be consistent with loss reporting.
- Classify employees correctly.
In general, if you stick to generally accepted accounting (GAAP) principles, your accounting and, therefore, your tax return will pass muster. Let’s talk specifics.
Your business probably won’t be audited.
The IRS audits around 1% to 3% of business tax returns.¹ But while the chances are low for small businesses, the consequences are high, so it’s important to be proactive to avoid them.
The IRS has stiff penalties.
An audit can lead to fines, interest on unpaid taxes, and additional taxes owed. If they think you intentionally misreported, you may even face criminal charges.
The most common is the 20% accuracy-related penalty.
If the IRS catches an underpayment, they’ll tack on a 20% penalty to the unpaid amount. So, for example, if you owe $100,000, you’ll end up paying back that amount plus an extra $20,000 in penalties. In total, we’re looking at $120,00.
Let’s look at how to avoid the five biggest red flags.
1. Report all of your income.
We’ll start with the most common audit trigger: failing to report all your income.
The IRS uses automated systems to match income reported on tax returns with third-party forms like 1099s and W-2s. If there’s a mismatch, it’ll raise an immediate flag that could lead to a letter from the IRS.
How to avoid this accounting mistake.
Report every dollar, including cash payments. Double-check the amounts on your tax return to make sure they match 1099s and other forms.
Don’t round down for entries. A lot of round numbers without cents are possible indications that income isn’t being reported accurately.
2. Don’t take unusually high deductions.
According to the IRS, a legitimate business expense has to be both “ordinary and necessary” to qualify as a deduction.²
Deductions that are excessive compared to income can attract IRS attention.
How to avoid this accounting mistake.
Keep detailed records of all income and expenses to guarantee accurate deductions. Business owners should diligently avoid claiming any personal meal or travel expenses as business expenses. Consult a tax professional; they can help verify that all of your claims are reasonable.
3. Avoid excessive cash transactions.
Businesses that handle a lot of cash, like restaurants or retail, are more likely to be audited because their activities are harder to trace. That lack of a paper trail makes it easier for errors to occur and can raise the IRS’ suspicions.
How to avoid this accounting mistake.
For many companies, a large amount of cash transactions is unavoidable. That’s okay. Business owners can still take steps to avoid triggering an audit. How?
First, keep a detailed log of cash transactions and regularly deposit them into your business account on a monthly basis. This is referred to as “reconciliation” and ensures that your books are in-line with your bank account. Second, don’t split large deposits into smaller amounts. The IRS considers this an attempt to get around reporting requirements referred to as “structuring,” and it’s illegal.³
4. Be consistent with loss reporting.
Occasional losses are understandable, especially if you’re just starting. But if you report losses year after year, you’ll raise suspicions. The IRS may question whether your business is actually profit-driven or if you’re using losses to illegally lower your tax liability.
How to avoid this accounting mistake.
Make sure all your losses are properly documented. As well as you can, avoid reporting losses several years in a row — it signals to the IRS that your business isn’t trying to make a profit.
5. Classify employees correctly.
If you misclassify your employees as independent contractors, you’ll be more likely to get an audit. The IRS has an eye out for this issue because it affects payroll taxes.
How to avoid this accounting mistake.
Make sure you’re correctly classifying every worker as either an employee or a contractor. Keep accurate records of all employment agreements. You should also occasionally review your payroll setup so you’re keeping up with employee compliance.
Follow my small business audit checklist to stay audit-ready.
Review and perform these five steps to ensure you’re aligning your business with best practices and heading off accounting mistakes before they happen.
- Make sure your books align with bank statements and other financial records.
- Maintain documentation for every expense and income source.
- Review tax filings for consistency across forms.
- Keep up your payroll records.
- Work with a tax professional to make sure your financial practices are above board.
Compliance is a process. You need to keep at it.
Number five on my audit checklist is key, so I’ll say it again: If you need help navigating the complexities of small business tax compliance, schedule a discovery call with us today.
Talk soon,
Jeremy A. Johnson, CPA
References
- Wiztax. IRS Small Business Audit: How Likely Are You to be audited?. 2024. Available from: https://www.wiztax.com/blog/irs-small-business-audit/
- IRS. Publication 334 (2024), Tax Guide for Small Business. Available from: https://www.irs.gov/publications/p334
- IRS. FAQ #2 – What is a structured transaction? Nov 15, 2024. Available from: https://www.irs.gov/government-entities/indian-tribal-governments/itg-faq-2-answer-what-is-a-structured-transaction.