11+ IRS Flags for Small Businesses: How to Avoid Audit Triggers

The IRS red flags for small businesses, also called tax triggers, are discrepancies on a taxpayer's or business owner’s tax return that prompt an investigation or audit from the Internal Revenue Service.

Often, these discrepancies on tax returns may be in the form of unreported income, excessive refundable credits/tax write-offs, or consecutively claiming a business loss.

In addition, there are several other types of inconsistencies in a tax return that could get your small business or startup in trouble if you’re not careful.

That is why, in this article, we will walk you through what the red flags for the IRS are, and you can double-check all the information you submit to the IRS to ensure you file your taxes correctly.

Let’s start!

Key Takeaways

• The IRS red flags for small businesses are inconsistent information on your tax returns or tax filing mistakes that could trigger an IRS audit.
• Some of the most common IRS red flags for small businesses include claiming excessive business expenses, rounding numbers on receipts or tax returns, making large donations, and misclassifying employees.
• Business owners can avoid a possible IRS audit by keeping complete and accurate records of each business transaction, having a contingency plan to regulate expenses, and filing their taxes on time.

11+ IRS Red Flags for Small Businesses That Can Trigger an Audit each

As there are various IRS red flags for small businesses, you may be committing some of these tax filing mistakes without even realizing it. To help you avoid that, we’ve enumerated some of the most common IRS audit red flags typically committed by small businesses below:

#1. Excessive Expenses

The first on our list of IRS red flags for small businesses is excessive expenses. Incurring multiple expenses while establishing and maintaining a business is understandable.

In truth, the IRS also allows business expenses to be written off on tax returns to reduce the taxes a business owner owes.

The condition is that these expenses must be legitimate business costs, which include business or work-related travel expenses, depreciation, or legal fees.

However, when these expenditures exceed your average business income, it raises the Internal Revenue Service’s suspicion.

The IRS may be prompted to take a closer look at your annual income and assess whether the business expenses you claim align with the nature of your business operations.

#2. Fluctuating and Excessive Business Income

If not claiming excessive expenses, reporting excessive business income could also put you under the watchful eye of the IRS. That is not to say that a thriving business with a consistent income stream is an IRS red flag for small businesses.

Instead, the issue lies in whether there are inconsistencies in your income or if the shift in your average earnings seems to happen instantly without any viable documentation to support it.

Another reason the Internal Revenue Service typically cracks down on fluctuating or excessive business income is that some business owners tend to underreport or hide income earned from the previous tax years.

#3. Round Numbers

Round numbers on your tax returns are considered IRS red flags for small businesses because all business transactions or payments involve dollars and cents.

As such, the presence of any whole or round numbers in your tax return could indicate estimated numbers or inaccurate profit and loss information.

Similarly, if your employees report round numbers on their W-2 forms, the IRS may suspect you of not withholding the correct amount for their income taxes.

#4. Large Charitable Donations

Itemizing all applicable tax deductions for volunteer work is one of the most common ways small business owners reduce their taxable income.

If business owners donate to tax-exempt organizations and claim valid and unreimbursed volunteer work expenses, they may claim a refund for their charitable work.

However, charitable donations are also common triggers of an IRS audit. This is particularly true if small businesses fail to file Form 8283 when writing off non-cash charitable donations that exceed $500.

The IRS may suspect the contribution is a way for business owners to falsify their tax deductions and try to reduce the taxes they must pay.

#5. Misclassification of Employees

Some business owners deliberately misclassify their employees in an attempt to reduce their business insurance and labor expenses.

As such, it is unsurprising that misclassifying employees is one of the many types of W-2 form corrections that could cause an IRS audit for employers and their employees.

For example, if an employer misclassifies their employees as independent contractors, it may lead to unnecessary discrepancies in their withheld income tax information and FICA tax payments.

#6. Cash Transactions

Businesses that generate profit in cash, such as salons and restaurants, are among the types of businesses that the Internal Revenue Service typically audits.

Cash-based profit is often included in the list of IRS red flags for small businesses because cash income is more likely to be underreported, regardless of whether the business earns a small or large sum annually.

Business owners must have complete documentation to support or verify their transactions if the IRS sees them for a possible audit.

#7. Failure to Report All Taxable Income

Every employer or business owner must report their taxable income annually as one of the basic rules of small business tax compliance.

The IRS system will review and cross-reference every document or tax form that reflects a business owner’s earnings.

That said, it is essential that business owners review every IRS form or proof of income in their records and ensure every taxable income is properly accounted for.

#8. Consistently Missing Payroll Tax & Filing Deadlines

The Internal Revenue Service has set tax filing deadlines for a reason—to ensure all taxpayers, individuals, and business owners alike have ample time to sort their receipts, proof of income, and records to report all of their taxes and earnings for the year.

The tax filing deadlines fall on the same dates every year. Sole proprietors must submit or attach their Schedule C (Form 1040) to their Form 1040 Individual Income Tax Return on or before April 15.

The tax filing deadlines also depend on the business owner’s preferred tax year. Corporations not categorized as S-corporations follow the same deadline as sole proprietors if they follow the calendar tax year.

If the corporation follows a fiscal tax year ending on June 30, the filing due date is on the 15th of the third month following the end of their tax year.

Partnerships, S-Corporations, and multi-member LLCs must file their tax returns on or before March 15 of each year unless they follow a fiscal year.

If a business owner consistently fails to meet their tax filing due dates, it is often a sign of their disregard for their obligations and a possible indication of deliberate tax fraud.

#9. Consecutive Business Losses

Consecutive business losses are considered IRS red flags for small businesses because they could imply that the business owner lacks proper documentation of their profit and losses.

This could also mean that a business owner may not be providing an accurate report of their annual earnings and revenue.

Additionally, they may also have questionable motivations for operating their business in the first place. There have been many instances in the past where startups would report net operating losses to try and offset their existing tax liabilities or debt.

#10. Excessive Tax Deductions

Several types of tax deductions for independent contractors also apply to self-employed individuals and startup owners. Examples of these tax deductions include home office, travel, vehicle use, self-employment tax, and health insurance deductions.

Determining what constitutes an excessive tax deduction claim on a small business’s tax return usually depends on the type of deduction or tax write-off being claimed.

For example, it would be suspicious for a sole proprietor to claim 100% in home office deductions or for a startup to claim a considerable amount in vehicle use or travel deductions.

Home office deductions only apply to the portion of a self-employed individual’s residential space used to operate their business.

Also, unless the business mainly offers logistics services or something similar, it is highly unlikely for startups to accumulate operational expenses consisting mainly of vehicle use or travel costs.

#11. Hobby Loss Claim

A hobby loss is any monetary loss incurred following the pursuit of a venture or business that the IRS categorizes as a leisurely or recreational activity.

The Internal Revenue Service treats hobbies differently from businesses, meaning small business owners cannot simply claim hobby expenses on their tax returns.

The IRS has a fact sheet that lists the different considerations in determining whether a taxpayer or business owner’s hobby loss claim falls under the many IRS red flags for small businesses.

#12. Early Payouts From 401(k) or IRA Accounts

The last item in this list of IRS red flags for small businesses involves withdrawing early payouts from 401(k) or IRA accounts.

Taking an early payout from one’s 401(k) or IRA account before reaching 59 ½ years old for no substantial reason is subject to a 10% penalty. The penalty is added to the regular income tax levied on the amount withdrawn from the retirement account.

There are exceptions that allow an early 401(k) or IRA payout, such as the need to pay medical bills or higher education expenses, disaster relief, or becoming disabled. Early payouts are also allowed if the taxpayer rolls over their account to another retirement plan within 60 days.

4 Best Practices and Tips for Avoiding IRS Small Business Red Flags

The key to avoiding the IRS red flags for small businesses listed in this article is implementing simple yet effective steps that enable business owners to stay on top of their operations and ensure every penny that goes in and out of their business is adequately accounted for.

Some of the best practices include:

#1. Using Professional Tools

Having complete and proper documentation of all expenses and transactions is essential when small business owners file their taxes later. With up-to-date records, business owners can easily explain all business-related transactions and payments to the IRS.

A convenient and practical way for business owners to ensure they document all their transactions is by using online tools like Paystub.org’s W-2 form or 1099 form generator, invoice generator, or paystub generator.

Our generators help startup owners create invoices for different client orders, furnish 1099 forms for their contractors, and prepare pay stubs for their employees in just a few steps.

All they have to do is fill in the blank template of their preferred type of online generator with the necessary information, preview the document, and print a physical copy or download a PDF version of the file.

#2. Keeping Your Records Accurate

Aside from documenting all transactions carried out while operating the business, ensuring that the information on all receipts, tax returns, and accounting records is correct is also vital.

Business owners must make it a point to verify all information in their accounting books and avoid incurring errors in their business or employees’ tax and income information.

In doing so, business or startup owners effectively avoid IRS audit triggers and penalties.

#3. Having a Contingency Plan

A clear and solid contingency or continuity plan enables small business owners to regulate operational costs and balance their revenue and expenses.

Establishing an effective continuity plan may include proper tax planning, effective budgeting, and improving the business’s existing marketing and customer acquisition strategies.

Contingency plans keep business owners from claiming several expenses on their tax returns. Consequently, they minimize discrepancies in their tax information and pay their tax dues accordingly.

#4. Filing Tax Returns On Time

Consistently meeting tax filing deadlines is one of the key IRS requirements for small businesses. It is a simple yet crucial step that prevents business owners from facing late filing penalties or incurring additional tax liabilities.

Business owners must make it a habit to align their payroll processing and accounting schedules with the set deadlines for filing their taxes.

In this manner, business owners can establish a smooth sailing process in accounting for their profits and losses, compensating their workers, and preparing all the tax documents required from their operations.

Final Thoughts

To summarize, the different IRS red flags for small businesses can be easily avoided with proper documentation, budgeting, and full compliance with all IRS regulations.

For some business owners, avoiding a potential IRS audit only requires simple steps, such as maintaining updated profit and loss records. Other business owners may have to pay existing tax debt or address existing discrepancies in their business information.

Regardless, business owners must prioritize addressing any errors or inconsistencies in their accounting records or operations to avoid facing more penalties in the future.

IRS Red Flags for Small Businesses FAQ

#1. What’s the worst that can come from an IRS audit?

The worst that can come from an IRS audit is that you owe the IRS more taxes than you previously did. You can also face penalties, heavy fines, or a lien or legal claim on your business.

#2. What happens in an audit?

Your business will receive an IRS audit letter in your mail during an IRS audit. Depending on whether you will face correspondence, office, or field audit, you may be required to submit a receipt or specific documentation within 30 to 60 days to the IRS.

You might have to submit your documentation via mail or post your response and supporting papers to the nearest IRS office or to an auditor.

#3. What types of businesses get audited the most?

Corporations and businesses that earn $100,000 or more get audited the most. While there is a chance for smaller businesses and startups to get audited, the probability is significantly lower.

It is also important to note that the IRS follows an internal scoring system to determine whether a business—regardless of size—has any discrepancy or error on its tax returns.

#4. What are common mistakes small businesses make on 1099s and W-2s?

Some common mistakes that small businesses make on 1099s and W-2s include underreporting the income paid to employees or independent contractors, misclassifying employees, or inputting incorrect tax or personal information of contractors and employees on their W-2 or 1099 forms.