Last week, I covered some common and lesser-known IRS red flags that can trigger audits for individuals. If you haven’t read it, check it out – it will help you prepare for tax season and avoid accidental missteps that could land you in trouble.
This week, I’m diving into IRS red flags for sole proprietors and business owners. There’s a lot of bad tax advice online that makes it seem like owning a business or having self-employed income gives you a free pass to write off nearly everything and slash your taxes to zero. You might hear the so-called “experts” suggesting shady things as writing off personal vacations labeled as “business trips,” deducting private chef costs as part of business meetings, or buying vehicles and claiming 100% of the cost without ever driving them.
Yes, business owners have more opportunities to reduce their tax bills but don’t be fooled - claiming excessive deductions or misusing write-offs can put a target on your back. If you blindly follow such advice without understanding the rules, it can lead to serious problems.
In this post, I’ll clear up the misconceptions and walk you through the red flags to avoid as a business owner, so you can stay compliant while protecting your bottom line.
Common IRS Audit Red Flags
Underreporting Business Income
One of the most common IRS audit triggers is underreporting income. The IRS has access to third-party payment systems like 1099-K forms from platforms such as PayPal, Square, or Stripe, as well as bank records. If your reported income doesn’t align with these documents or industry benchmarks, it raises a red flag.
Always ensure all income, whether through cash or digital means, is accurately reported.
Repeated Late Payroll Tax Filings
Speaking of compliance, payroll taxes are another area where small businesses often get tripped up. Consistently missing payroll tax deadlines or failing to file is a major red flag for the IRS, leading to penalties and increasing the likelihood of an audit. To mitigate this risk, ensure payroll taxes are filed accurately and on time using reliable systems, keeping detailed records, and consulting professionals if needed.
Large Cash Transactions
If you are running a business that deals heavily in cash like restaurants, taxis, or small retail shops, the IRS will naturally keep a closer eye on you because they know that cash is harder to track. That’s why meticulous record-keeping is your best defense. Keep detailed logs of every dollar coming in and going out and always file Form 8300 for cash transactions over $10,000.
Trying to structure transactions to avoid this threshold - known as “smurfing” - can result in severe penalties.
Misclassifying Employees
Another area to watch out for is how you classify your workers. Misclassifying employees as independent contractors to save on payroll taxes or labor costs is something the IRS takes very seriously.
If you control what work is done and how it’s done, that person is likely an employee, not a contractor.
To stay compliant, follow IRS guidelines on worker classification, and don’t forget to issue the appropriate forms - W-2 for employees and 1099-NEC for contractors. And if you hire independent contractors, keep detailed records of the work they’re doing for your business.
Excessive Expenses
Let’s talk about expenses and losses. While it’s tempting to write off as much as possible, excessive or inconsistent expenses can attract IRS attention. For example, charging all your meals during the workday as business expenses might seem harmless, but it’s a red flag. It’s okay to claim legitimate expenses - just make sure they’re reasonable and well-documented.
Losses Year After Year
If your business shows losses year after year, the IRS may start questioning whether it’s a legitimate business or just a hobby. They expect businesses to eventually turn a profit. To avoid raising suspicion, make sure you have thorough records and can demonstrate that your business operates with the intent to generate income.
If you’re self-employed, you might be inclined to classify personal expenses as business expenses on Schedule C. The IRS agents know that self-employed people frequently claim excessive deductions and don’t report all their income. So, before trying to write off that new smartphone you bought for "work," think about how consistently reporting losses could raise red flags. The IRS could start questioning how your business stays afloat.
Net Operating Loss Carrybacks or Carry-Forwards
Another important aspect of business losses is that they can be carried back or forward to different tax years. This is a widely used tax strategy, but if not handled correctly, it can catch the IRS’s attention. Proper documentation is essential to demonstrate that your business losses are legitimate and comply with tax regulations.
Excessive Deductions to Your Income
Now, it’s important to talk deductions, because this is where the IRS loves to dig deeper. While they’re a great way to reduce your taxable income, they must be reasonable and directly tied to your business. According to the IRS, expenses must be both ordinary (common in your trade) and necessary (helpful and appropriate).
Claiming deductions far above what’s typical for your industry can attract unwanted attention.
For instance, writing off 75% of your income as business expenses is a major red flag unless you can provide solid documentation.
Overstating deductions for employee benefits like meals, entertainment, or travel is another common trigger. For example, claiming a trip to a tropical destination as a “business meeting” without clear documentation can invite an audit. Keep detailed records of who attended, the purpose of the trip, and how it relates to your business.
Section 179 Vehicle Write-Off
Finally, let’s dive into the buzzworthy Section 179 write-offs that are all over the internet. This provision allows businesses to deduct the full purchase price of qualifying equipment and software purchased or financed during the tax year. While the Section 179 write-off isn’t an automatic red flag, it can draw IRS scrutiny if misused.
A popular tactic promoted by online bloggers is to buy a Range Rover or other heavy vehicles over 6,000 pounds and write off 100% of the cost in the year of purchase. But be cautious with this advice as there are strict rules to follow.
Specifically, the vehicle must be used for business purposes more than 50% of the time, and if you can’t prove it, there is a very high chance that the IRS will knock on your door.
On a related note, claiming 100% business use of a vehicle, especially if the vehicle is something like a sedan rather than a specialized business vehicle, is another red flag to be aware of. To take this deduction, you’ll need to keep detailed mileage logs showing how the vehicle is used for business versus personal purposes. Without proper documentation, you risk having the deduction denied and facing penalties.
Lesser-Known IRS Audit Triggers
Now, let’s shift to some triggers that might not be as obvious but are equally important.
High & Low Salaries for Owners
If you run an S-Corp and pay yourself an unusually high salary while leaving little for business profits, the IRS may take notice. Conversely, paying yourself a low salary to avoid payroll taxes can also be problematic. Strive for a reasonable salary based on industry standards and your role within the company.
Inventory Discrepancies
If your business manages inventory, inconsistencies in reporting beginning and ending inventory levels can catch the IRS’s attention. If your inventory costs fluctuate wildly without explanation, the IRS might dig deeper into your books. Using proper accounting methods and reconciling inventory levels regularly can help avoid this.
Misusing the Research and Development Credit
The Research and Development credit is a valuable tax break but a common target for IRS audits. The IRS flags fraudulent claims and promoters pushing businesses to misuse the credit by inflating expenses or claiming routine activities.
To qualify, research must involve experimentation and address uncertainty. Activities like customer-funded research, adapting existing products, or post-production work don’t qualify.
Misuse of the R&D credit can lead to serious IRS scrutiny.
Not Paying Self-Employment Tax
Some limited partners and LLC members who don't file Schedule SE or pay self-employment tax are on the IRS's radar. The agency has an ongoing audit campaign involving the issue of when limited partners and LLC members in professional service industries owe self-employment tax on their distributive share of the firm's income.
Tiered Partnerships
Finally, let’s touch on partnerships, a key area where the IRS is ramping up scrutiny.
Partnerships, particularly those that don’t pay corporate income taxes, are under the microscope.
Tiered partnerships - structures where one partnership owns another partnership - are under heightened scrutiny because they can be used to obscure income or shift profits to avoid taxes.
This type of layering makes it harder for the IRS to trace the flow of income, but with increased resources and sophisticated audit techniques, they are cracking down on these practices. If you are involved with partnerships, make sure that income and deductions are accurately reported to avoid raising red flags.
Valuation Discounts
Another focus for the IRS regarding partnerships is the use of valuation discounts to reduce transfer taxes on assets for future generations. While valuation discounts are a legitimate estate and tax planning tool, using overly aggressive discounts to significantly undervalue assets can trigger an audit. The IRS carefully evaluates these cases to ensure that discounts accurately reflect the market value of the assets and aren’t being used to evade taxes.
Proper documentation and professional appraisals are essential to defend any valuation discounts claimed.
Final Thoughts
Navigating IRS red flags as a business owner can feel overwhelming, but with the right knowledge and preparation, you can confidently minimize your risk. The key is to be proactive: report all income accurately, file payroll taxes on time, and ensure deductions and losses are well-documented and within the boundaries of IRS rules. Don’t be tempted by flashy online advice or shortcuts that promise big savings but come with big risks.
If you’d like to explore strategies to reduce taxes for your business, feel free to schedule a complimentary meeting today.
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