3 Red Flags That May Trigger an IRS Audit of Your Small Business

You can’t avoid death or taxes — but you may be able to avoid a tax audit, according to Scott F. Berger, tax and entrepreneurial services principal at Kaufman Rossin, who has represented businesses in IRS audits for 25 years. Although he acknowledges that “audits are at an all-time low” due to budget constraints, small businesses may be able to reduce their chances of an audit even more by being mindful of what Berger calls “red flags.”

1. Business Losses

“If [the IRS sees] a sole proprietorship with a loss, I can tell you your chance of audit is extremely high,” says Berger. Sole proprietorships are particularly suspicious, in the eyes of the IRS, because owners often commingle personal and business expenses and may take deductions to which they are not entitled.

If your business comes up in the red at tax time, Berger recommends looking carefully at whether your deductions are all allowed under the tax code. “Everyone likes to think every dinner out is a business expense,” he says. “You want to look to see, really, is it a business expense and valid?”

While Berger says the IRS is unlikely to audit a startup that loses money in its first year, he cautions that many entrepreneurs fail to account for their startup expenses correctly. “Businesses are required to capitalize certain expenditures,” he says, spreading deductions for large purchases and pre-startup expenses over multiple years. “Many times small businesses do not do that.”

2. Cash Transactions

Credit-card processors now submit 1099-K forms to the IRS with a record of your business’ total credit-card transactions for the year. The IRS has a (secret) formula that tells it how much a business should have in cash sales based on its total credit-card transactions.

“Just because you didn’t get the actual notice of audit,” says Berger, “doesn’t mean that they’re not checking behind the scenes.”

3. Math Mistakes

You might get flagged for an audit, Berger says, “if you’ve added up your receipts and they don’t agree with the 1099-K.” The IRS is always checking math on the returns, so getting the numbers right is crucial.

The fact that most tax returns are done electronically helps, he notes, because tax prep software does the math for you. Still, Berger recommends that small-business owners double-check their returns. “You should know your numbers and you should know your business. The accountant should know the tax law,” he says. “You’re signing your tax return, so you’re responsible for the numbers on it.”

Keep Your Financial House in Order

A best practice for sole proprietorships is to “clearly segregate your business from your personal life,” says Berger. Use separate bank accounts and credit cards for business and personal expenses.

He notes that audits usually occur two to three years after you file a return, and reconstructing your records years after the fact can be difficult. His advice is to prepare your books as if you were about to be audited. “The best thing is to be prepared for the audit, even if you don’t get examined,” Berger says. “The pain of not being ready is worse than the actual audit itself.”