5 Common Triggers for Small Business IRS Audits: How to Stay Prepared

IRS audits can be a source of anxiety for both individual taxpayers and small business owners. In recent years, the IRS has increased its focus on auditing small and medium-sized businesses, especially those with relatively low annual revenue. While there’s no foolproof way to avoid an audit, being aware of common red flags and taking preventive measures can significantly reduce your risk. In this blog post, we’ll explore five reasons why small businesses get audited and provide tips on how to minimize your audit risk.

1. Reasonable Salary Small businesses structured as S-Corporations need to pay their shareholder-employees reasonable salaries. Paying an unreasonably low or high salary can trigger an audit, as it may be an attempt to avoid payroll taxes. Determining what constitutes “reasonable compensation” can be complex, but conducting market research and ensuring your salaries align with industry standards can help you stay in compliance.

2. Losses and Deductions While itemizing deductions is common for small business owners, having an excessive number of deductions can raise red flags. Deductions must meet the criteria of being both “ordinary” and “necessary” for your trade or business. Keep meticulous records, retain receipts, and ensure your deductions align with IRS guidelines to avoid scrutiny.

3. Shareholder Distributions Shareholder distributions must be handled alongside reasonable compensation. Making distributions without providing proper compensation can attract IRS attention as an attempt to avoid payroll taxes. Understand your options, which include no compensation, reasonable compensation, or a combination of both. Be aware that retroactive distributions may come with additional costs.

4. Employment Tax Compliance Misclassifying workers as independent contractors when they should be employees is a common audit trigger. Independent contractors should have control over their schedules, work assignments, and conditions. Review IRS guidelines carefully when hiring new workers to avoid misclassification and potential liabilities.

5. Entity-Level Issues Businesses that deal primarily in cash transactions, such as restaurants or beauty salons, may face a higher risk of audits due to the difficulty of tracking cash income. While cash transactions are essential for some businesses, maintaining impeccable records and accurately reporting income is crucial to minimize audit risk.

While IRS audits remain a concern for small businesses, understanding these common triggers and taking proactive steps to address them can help you reduce your audit risk. Ensuring reasonable compensation, careful deduction reporting, proper handling of shareholder distributions, accurate worker classification, and diligent record-keeping can go a long way in keeping your small business in compliance with tax regulations. Remember, being prepared and informed is your best defense against potential audits.