We all know that with any business, taxes are inevitable, and the worst case scenario for any business owner would probably involve a tax audit from the IRS. That’s why one of the most important things you can do for the financial well-being of your business is to pay your taxes on time – and to pay them correctly! You can certainly mitigate your risk by filing on time, but it’s absolutely crucial to stay vigilant for red flags that could trigger an audit. Following are a few of these that you’d be wise to avoid:
Deducting Business Meals and Lodging
It may be challenging to keep track of your business expenses that qualify as deductions, so keeping detailed records is key. Here’s how.
To qualify for a meal deduction, keep detailed records of the following:
- The total amount spent, including tax and tip
- The name and location of the restaurant
- A list of people who were at the restaurant with you
- The purpose of having the business meeting over a meal
While it’s tempting to treat every dinner out as a business expense, you need to examine whether each meal expense you claim is valid, and using the checklist above can help you determine that. Meanwhile, when you’re on the road for business, you’ll want to keep receipts for expenditures of $100 or more. As a back-up to your receipts for hotels, meals, and entertainment, you may also want to keep records of relevant conferences or meetings that you attended during the time you were out of town on business.
Failure to Report or Pay Employment Taxes
Whatever your reason for missing a deadline, not paying payroll taxes is a big red flag for the IRS and other tax agencies. An employer is required to withhold federal income and payroll taxes from its employees’ wages and pay them to the IRS. Often, company officers do not want to be bothered with tax matters and it is not uncommon for a CEO to instruct an employee to take care of the payroll taxes. If that employee fails to accurately report and pay the payroll taxes, the officer had better be concerned. Delegation of authority does not relieve a person of responsibility to collect and pay taxes to the IRS. As an employer, collecting, reporting, and remitting payroll taxes are some of your primary responsibilities, so if you forget, neglect, or delegate your obligation, your small business could receive a penalty, but worse, it could lead to that dreaded audit!
S-Corp Owners Not Taking Wages
The IRS expects S-Corp owner-employees to pay themselves a reasonable employee salary, which would be commensurate with at least what other businesses pay for similar services. For tax purposes, an owner of an S-Corp who performs more than minor services for the corporation, wears at least two hats. In effect, an active shareholder in an S-Corp is a shareholder (owner) of the corporation, and is considered an employee of that same corporation. Owners who consistently do not take wages or report profits are risking raising a red flag to the IRS and other tax agencies. At the end of each year, all S-Corporation profits are allocated to the corporation's shareholders. If you opt to leave some or all of the profits in the corporation, you’d still be required to pay tax on those profits, even if you take no wages and no distributions. You must report your share of the earnings, losses, deductions, and credits on the K-1 schedule. As an owner, you must be cognizant of these laws to avoid putting up red flags.
Reporting a Business Loss
If you report a loss to the IRS, your chance of being audited may be higher, especially if it is a sole proprietorship. Since owners often intermingle their personal and business expenses, the IRS tends to be very suspicious of these deductions. Unless you’re keeping rigorous, detailed financial records, it’ll be very difficult to justify your deductions to the IRS, causing you to potentially lose out on entire deduction categories. We recommend taking a close look at your deductions, making absolutely sure that they’re allowed under the tax code.
Home Office Deduction
You need to have a dedicated space in your home that is exclusively used for business to take advantage of this deduction. When you claim this deduction, you have to figure out exactly how much square footage is dedicated to your business in your home vs. how much square footage you have in your home at large. In this way, you may be able to prorate some household expenses such as utility bills and homeowner’s association fees on a fractional basis. Of course, in order to avoid being suspected of abusing this type of deduction, you’ll need to be prepared to prove that the area in which you claim to be working is in fact separate from the rest of your home, and that it is only used for business purposes.
The IRS will be consistently checking the math on your returns, so it’s imperative that you are 100% accurate with your numbers. Once you’ve ensured that all your deductions are legal, and supported by your financial records, double-check your calculations and make sure that everything make sense. Once you sign your name on that tax return, you’re responsible for the math errors as well as the numbers.
Maintaining Financial Order
If you strictly separate your business expenses from your personal finances, you will minimize your risk of being flagged for an audit. One of the best ways you can prevent an audit is to keep precise, comprehensive financial records. These records will act as your justification for the deductions you take and protect you from losing part (or all) of your deductions.Always aim to use two separate credit cards for business and personal expenses.
In every case, make sure that all your financial records are easily accessible and in chronological order, as the IRS will ask you to turn them over in the event of an audit. Remember, awareness and diligent record-keeping are your two best allies when it comes to avoiding an audit in the first place!