The last thing any business owner wants is to be audited by Uncle Sam. Truthfully, the probability of an audit is generally low though some red flags can trigger a business audit. These red flags seem to raise an eyebrow, so you should know them:
Excessive Income Specified on Schedule C
Judging by the 2018 Data from IRS statistics, the rate of audit for people who have income between a million-dollar and $200,000 who didn't file Schedule C was just 0.6%. However, the rate increased to 1.4% for all schedule C filers in the similar category.
For schedule C filers who report more than $1 million, the rate of audit was pretty higher.
Little or Missing Salaries for S-Corp Shareholders
A lot of small business owners establish an S-Corp, rather than an LLC, to dodge the 15.3% self-employment tax. Shareholders of S-corps will not pay the self-employment tax for their distributions even though they need to pay reasonable compensation provided they work as an employee. Such compensation is specified as a wage on W2.
Uncle Sam is on the hunt for S-Corps that have excessively low salaries or the ones that paid no salaries to shareholders. For people with compensation that is out of the normal range for your job designation and the company's size, alongside profitability, that is a red flag signaling audit.
Too Many Expenses with Disproportionate Deductions
Small businesses need deduction, especially in the startup years when they are not making much money yet. You can claim any deduction that your business is eligible for. However, all deductions that do not correspond to your own business are an audit trigger. Any huge increase in expense or deduction might likely raise some eyebrows.
Uncle Sam has its criteria alongside the calculation method to estimate the excessive deduction value for the income bracket. Sadly, such information is not public knowledge. However, you can significantly bring down your audit risk by claiming ordinary and necessary deductions only.
A typical audit that will draw Uncle Sam's attention is home office deductions, travel expenses, etc. This is because of the tendency of people to misuse it.
Excessive Number of Employees Vs. Independent Contractors
Right from state tax agencies, this tax audit starts beaming even before getting to Uncle Sam.
States like going after businesses that hire an excessive number of freelancers or independent contractors. This is because businesses will not need to pay the payroll taxes of the state like disability and unemployment for freelancers as they will for employees. They also will not pay the payroll taxes of the federal government, and they are excluded from Medicare and Social Security.
Many businesses employ this as a money-saving tip that can come back to haunt them big time should those supposed freelancers be actual employees. If any firm is caught misclassifying its workers, the state will alert the IRS while such a firm will deal with their state penalties as well. The state and federal tax agencies are keen on ensuring that all firms properly remit their payroll taxes.
This does not mean using an independent contractor is bad for your business. However, you need to comply with the Worker's classification alongside your state's rule. It could be a challenging endeavor as there has not been a single test to ascertain a worker's status.
Shortcuts and Mistakes
Uncle Sam is also interested in ensuring that you got your Math right. As a result, wrong totals, missing 1099s, and innocent errors like transposed numbers will raise some eyebrows.
The IRS believes that if there is a shortcut or mistake in your tax, as sensitive as it is, other sectors of your finances could have errors as well.
Excessive Cash Transactions
Businesses with huge cash transactions tend to get on the radar of Uncle Sam since such income is hard to track compared to credit card, checks, PayPal, and bank transactions.
Uncle Sam has some method to determine the ideal normal amount for all-cash transactions for various business types. One needs detailed documentation of every cash transaction if you want Uncle Sam to believe you. Also, you need to file Form 8300 that you will need to report all cash transactions more than $10,000.
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